Higher highs are no surprise to those who have embraced the market trend since the 2009 extreme lows. The scoreboard shows a 140% gain in the blue-chip Dow Jones Industrial Average and a 165% return for the broad-market S&P 500 index since the bear market lows. But the leading index, by a large margin, is the Nasdaq, with a 200%-plus gain for that same period.
This year is no different, with the tech sector outpacing the rest of the market. But one large-cap technology company that has failed to keep up this year is EMC Corporation (NYSE:EMC).
EMC rose from is 2008 lows near $8 to a high above $27 in September. The stock has since backed off to $24, about 12% below its peak. This could provide a good entry point, especially if EMC plays catch-up with the Nasdaq.
During the past year, EMC has traded between $27 and $22, consolidating while it searched for its true direction.
A push above the $24.50 midpoint of the past year’s trading action would renew the bullish trend and set EMC up for an attack on the yearly high.
The first target is a $5 move on a breakout of the trading range to $32. In the bigger picture, EMC has traded between $20 and $30 since the 2010 pivot. That puts the longer-term target at $40.
The initial $32 target is about 33% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see a 140% return 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 One: 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 CBOE.
With EMC trading near $24 at the time of this writing, an in-the-money $20 strike call option currently has about $4 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option currently has a delta of about 79.
Rule Two: 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 EMC Jan 2015 20 Calls at $5 or less.
A close below $21 in EMC 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 $500 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend over a year to develop.
This trade breaks even at $25 ($20 strike plus $5 options premium). That is only about $1 away from EMC’s recent price. If shares hit the $32 target, then the call options would have $12 of intrinsic value and deliver a gain of 140%.
Recommended Trade Setup:
— Buy EMC Jan 2015 20 Calls at $5 or less
— Set stop-loss at $2.50
— Set initial price target at $12 for a potential 140% gain in 14.5 months
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