A Bet On This American Icon Could Net You 80% Gains
By Alan Knuckman | September 19, 2014 |

Do you remember when the doomsayers were calling for a financial meltdown in China? Turns out fears of a banking system collapse and economic slowdown were greatly exaggerated. But traders are right to pay close attention to what goes on in China, as it is an important barometer of global economic activity.

China and other Asian nations are expected to lead global spending for capital projects and infrastructure, which is estimated to top $9 trillion a year by 2025, according to a new report by PwC and Oxford Economics.

Beneficiaries of this trend include companies that make heavy machinery, such as American icons Deere & Company (NYSE: DE) and Caterpillar (NYSE: CAT).

This brings me to an interesting chart. Below you can see how closely correlated the two stocks have been for much of the past five years. Yet, in 2014, CAT is up 15% while DE is down 9%.

This divergence presents a near-term bullish opportunity in Deere.

CAT vs DE Stock Chart

Shares of DE appear to have made a higher low this week versus their 52-week lows. If they can break through the midpoint of the sell-off from the May highs to the recent lows, which is near $87, it would target a recovery to the $92 area.

Multiyear support at $80 sits below. Only a close below this level on a weekly basis would negate the basing pattern.

DE Stock Chart

The $92 target is about 10% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make almost 80% 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 DE trading near $83.57 at the time of this writing, an in-the-money $75 strike call option currently has about $8.57 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 81.

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 recommend the DE Mar 75 Calls at $9.50 or less.

DE Call Option

A close below $80 in DE on a weekly basis or the loss of half of the options 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 March options give the bull trend six months to develop.

This trade breaks even at $84.50 ($75 strike plus $9.50 options premium). That is less than $1 above DE's recent price. If shares hit the $92 target, then the call option would have $17 of intrinsic value and deliver a gain of nearly 80%.

Recommended Trade Setup:

-- Buy DE Mar 75 Calls at $9.50 or less
-- Set stop-loss at $4.75
-- Set initial price target at $17 for a potential 79% gain in six months

Note: My colleague Amber Hestla is also bullish on DE and just recommended another call option strategy. Hers involves buying the shares and then "renting" them to other investors to generate income. Using this strategy, she's been able to earn $1,200 or more each month. Click here to learn more.

This article originally appeared on ProfitableTrading.com: Under $1,000 Bet on This American Icon Could Net You 80%

 

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