Income Play On Starbucks Could Earn 190%

Friday, May 2, 2014 - 10:30am

by Alan Knuckman

Starbucks (Nasdaq: SBUX) has stalled out following an 85%-plus run from its October 2012 low to the November 2013 high.

For more than eight months, the stock has traded in a roughly $10 range between $80 resistance and $70 support. The first upside goal is a recovery to the channel top at $80. If shares can break above that resistance, we could see a $10 jump to $90.

The $80 target is about 13% higher than recent prices, while the $90 target represents a 27% move. But traders who use a capital-preserving stock substitution strategy could make up to 190% returns on a move to that level.

One major advantage of using a long call option rather than buying a stock outright is putting up much less capital to control 100 shares -- that's the power of leverage. But with all of the potential strike and expiration combinations, choosing an option can be a daunting task.

You want to buy a high-probability option that has enough time to be right, so there are two rules traders should follow:

Rule 1: Choose a call option with a delta of 70 or above.
An option's strike price is the level at which the options buyer has the right to purchase the underlying stock or ETF without any obligation to do so. (In reality, you rarely convert the option into shares, but rather simply sell back the option you bought to exit the trade for a gain or loss.)  

It is important to buy options that pay off from a modest price move in the underlying stock or ETF rather than those that only make money on the infrequent price explosion. In-the-money options are more expensive, but they're worth it, as your chances of success are mathematically superior to buying cheap, out-of-the-money options that rarely pay off.

The option's delta approximates the odds that an option will be in the money at expiration. It is a measurement of how well an option follows the movement in the underlying security. You can find an option's delta using an options calculator, such as the one offered by the CBOE.

With SBUX trading near $70.60 at the time of this writing, an in-the-money $62.50 strike call option currently has about $8.10 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option has a delta of about 80.

Rule 2: Buy more time until expiration than you may need -- at least three to six months -- for the trade to develop.
Time is an investor's greatest asset when you have completely limited the exposure risks. Traders often do not buy enough time for the trade to achieve profitable results. Nothing is more frustrating than being right about a move only after the option has expired.

With these rules in mind, I would recommend the SBUX Oct 62.50 Calls at $9.50 or less. 

A close below $65 in SBUX on a weekly basis or the loss of half of the option's premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $950 or less paid per option contract. The upside, on the other hand, is unlimited. And the October options give the bull trend almost six months to develop.

This trade breaks even at $72 ($62.50 strike plus $9.50 options premium). That is only about $1.50 above SBUX's recent price. If shares hit the initial $80 target, then the call option would have $17.50 of intrinsic value and deliver a gain of 84%. The secondary $90 target would produce $27.50 in intrinsic value for a 190% gain.

Action to Take -->
-- Buy SBUX Oct 62.50 Calls at $9.50 or less
-- Set stop-loss at $4.75
-- Set initial price target at $17.50 for a potential 84% gain in 5.5 months
-- Set secondary price target at $27.50 for a potential 190% gain in 5.5 months

This article was originally published at ProfitableTrading.com: 
Under $1,000 Bet on Starbucks Could Make Traders Up to 190%

P.S. I just finished reading a special report by my colleague, Amber Hestla, about how investors can consistently and reliably pull income from the options market. And you don't have to be a sophisticated trader to do it. Go here to learn more.

Alan Knuckman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of SBUX in one or more of its “real money” portfolios.