The Dow Jones Industrial Average staged an impressive rally Wednesday, but the blue-chip index has lagged the other major indices so far in 2014. Its 2.5% year-to-date gain pales in comparison to the S&P 500's 6.5% return and the Nasdaq's 7%. And more than one-third of the Dow 30 components are in the red for the year.
Global fast-food icon McDonald's (NYSE: MCD) is off 3.5% year to date and has significantly underperformed the Dow in the past 52 weeks.
MCD dropped nearly 13% from a high of $103.78 in May to a low of $90.53 on Sept. 10. But the stock staged a major reversal from those lows, closing higher on the day. The new price low did not come with new highs in volatility, creating a bullish divergence that suggested sellers were exhausted.
My first objective is $99, which is near the midpoint of the May-to-September decline. A move above that would target a run to the previous highs.
The $99 target is about 6% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 47% 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 MCD trading near $93.83 at the time of this writing, an in-the-money $85 strike call option currently has about $8.83 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 86.
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 MCD Mar 85 Calls at $9.50 or less.
A close below $90 in MCD 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 over five months to develop.
This trade breaks even at $94.50 ($85 strike plus $9.50 options premium). That is less than $1 above MCD's recent price. If shares hit the $99 target, then the call option would have $14 of intrinsic value and deliver a gain of nearly 50%.
Recommended Trade Setup:
-- Buy MCD Mar 85 Calls at $9.50 or less
-- Set stop-loss at $4.75
-- Set initial price target at $14 for a potential 47% gain in 5.5 months
Note: There's another call option strategy that lets you earn $1,200 or more each month from the stocks you already own -- by "renting" them out to other investors. To learn about this easy process, click here.
This article originally appeared on ProfitableTrading.com: Fast-Food Icon Could Make Traders 47% in 6 Months or Less