Currency fluctuations are driven by global economic strength or weakness, and recently fear has increased demand for the safety of U.S. dollars as growth in China and Europe has slowed. These short-term crises have not, however, solved the larger negative fundamentals of the greenback.
The dollar has actually gained more than 10% since the lows in 2008 in the face of the Federal Reserve's printing proficiency. But a dollar demise seems imminent, and the extremely low volatility in the widely traded PowerShares DB US Dollar IndexBullish (NYSE: UUP) exchange-traded fund (ETF) sets up an attractive options play.
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UUP has traded quietly in a $2 range between $21 and $23 for almost two years. A downside breakout of the trading range targets a move to $19, which is 14% lower than current levels.
Rather than shorting the stock outright for a potential 14% gain, traders who buy put options on UUP could make triple-digit profits on a move to that level.
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One major advantage of using put options rather than shorting shares is putting up much less 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 70%-plus probability.
Delta is a measurement of how well an option follows the movement in the underlying security. It is important to buy options that pay off from a modest price move in the stock or ETF rather than those that only make money on the infrequent price explosion.
Any trade has a 50/50 chance of success. Buying in-the-money options increases that probability. Delta also approximates the odds that the option will be in the money at expiration. 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.
For example, with UUP trading at about $22 at the time of this writing, an in-the-money $23 strike put currently has $1 in real or intrinsic value. The remainder of any premium is the time value of the option.
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.
I recommend the UUP Jan 2014 23 Puts at $1.50 or less.
A loss of half of the options premium would trigger an exit. If you do not use a stop, then the maximum loss is still limited to the $150 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bear trend over a year to develop.
This trade breaks even at $21.50 ($23 strike minus $1.50 option premium). That is about 50 cents below UUP's current price. If shares hit the downside breakout target of $19, then the option would deliver a gain of almost 170%.
Action to Take --> Buy UUP Jan 2014 23 Puts at $1.50 or less. Set stop-loss at 75 cents. Set initial price target at $4 for a potential 167% gain in 14 months.
-- Alan Knuckman
Alan Knuckman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.