The S&P 500 Index has bounced back from its healthy 6% sell-off and is again within spitting distance of its all-time high. And while the automotive industry's recovery cannot be underestimated, shares of former blue-chip and Big Three automaker General Motors (NYSE: GM) are struggling, down 11% year to date.
After being booted from the Dow 30 back in 2009 after filing for bankruptcy protection, GM relaunched as a publicly traded company in November 2010.
Coming off a July 2012 low, shares rocketed to a peak just below $42 in late December 2013. They now sit 13% below their highs, making them a great bargain.
GM has two-year midpoint support at $30. A recovery to the highs near $42 following the recent pullback to $34 projects a measured move to $50. Only a weekly close below $30 would negate the technical pattern.
The $50 target is about 37% higher than recent prices, but traders who use a capital-preserving stock substitution strategy could make triple-digit profits 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 options Greek 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 Chicago Board of Exchange.
With GM trading near $36.50 at the time of this writing, an in-the-money $30 strike call option currently has about $6.50 in real or intrinsic value. The remainder of the premium is the time value of the option. As of this writing, this call option had a delta of about 82.
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 GM Jan 2015 30 Calls at $7.40 or less.
A close below $30 in GM 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 $740 or less paid per option contract. The upside, on the other hand, is unlimited. And the January options give the bull trend 11 months to develop.
This trade breaks even at $37.40 ($30 strike plus $7.40 options premium). That is only about $1 away from GM's recent price. If shares hit the $50 target, then the call option would have $20 of intrinsic value and deliver a gain of 170%.
Action to Take -->
-- Buy GM Jan 2015 30 Calls at $7.40 or less
-- Set stop-loss at $3.70
-- Set initial price target at $20 for a potential 170% gain in 11 months
This article was originally published at ProfitableTrading.com:
Former Blue Chip Could Score Traders 170% Profits by 2015