Energy prices are on the move once again with crude oil solidly above $100 a barrel and at 18-month highs.
Shares of offshore drilling company Transocean LTD (NYSE:RIG) have been trading in a $20 range between $60 and $40 since August 2011. Transocean LTD (NYSE:RIG) has been a market laggard in the past year, down 2% while most stocks have pushed higher.
Support at $40 has held with a 52-week low of $43.65. The stock actually has stair-step support, first at $46 from the past six months, then at $44 dating back to the second half of 2012, and finally, at $40 from a double bottom made in December 2011 and June 2012.
The midpoint of the two-year range sits at $50. A push above that level targets a move to the top of the channel at $60, with a longer-term price objective of $80 on a breakout of the trading range.
The $60 target is about 26% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could more than triple their money on a move to that level.
One major advantage of using long call options 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.
Simply put, 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 an 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 Transocean LTD (NYSE:RIG) trading at about $47.50 at the time of this writing, an in-the-money $44 strike call option currently has $3.50 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 70.
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 Transocean LTD (NYSE:RIG) Jan 2014 44 Calls at $4.75 or less.
A close below $44 in Transocean LTD (NYSE:RIG) 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 $475 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend more than five months to develop.
This trade breaks even at $48.75 ($44 strike plus $4.75 options premium). That is only about $1.25 above Transocean LTD (NYSE:RIG)’s current price. If shares hit the $60 target, then the call options would have $16 of intrinsic value and deliver a gain of more than 200%.
Recommended Trade Setup:
— Buy RIG Jan 2014 44 Calls at $4.75 or less
— Set stop-loss at $2.37
— Set initial price target at $16 for a potential 237% gain in five months
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