Fears that the Federal Reserve's quantitative easing program would decimate the U.S. dollar have proven unfounded. Despite all the so-called money printing, the greenback is at a four-and-a-half-year high versus a basket of currencies.
The run in the dollar may have exhausted itself though, as we saw key reversals in gold and the euro on Friday.
The CurrencyShares Australian Dollar ETF (NYSE: FXA), which tracks the Australian dollar's movement against the U.S. dollar, also rallied Friday.
This fund experienced a sharp sell-off beginning in September, but the recent lows in price did not come with new highs in volatility. This is known as a bullish divergence and often signals an end to the selling. Furthermore, the low levels of volatility currently could be signaling a big move in the fund's future.
At these levels, the risk/reward favors the bulls with strong, five-year support below at $80.
FXA has largely traded in a range between $94 and $86 for the past year. A recovery to the $90 midpoint could spur a run back to the $94 resistance top.
The $94 target is about 8% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 70% 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 FXA trading near $87.22 at the time of this writing, an in-the-money $80 strike call option currently has about $7.22 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 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 recommend the FXA Jan 2016 80 Call at $8.25 or less.
A close below $82 in FXA 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 $825 or less paid per option contract. The upside, on the other hand, is unlimited. And the 2016 options give the bull trend more than a year to develop.
This trade breaks even at $88.25 ($80 strike plus $8.25 options premium). That is only about $1 above FXA's recent price. If shares hit the $94 target, then the call option would have $14 of intrinsic value and deliver a gain of 70%.
Recommended Trade Setup:
-- Buy FXA Jan 2016 80 Call at $8.25 or less
-- Set stop-loss at $4.12
-- Set initial price target at $14 for a potential 70% gain in 14 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: A Bet on This Down Under Fund Could Make Traders 70%