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Coffee Stock's Breakout Could Net You 70% With This Trade

 December 11, 2012 11:07 AM

The wholesale price of coffee is down 40% on the year from $2.50 to $1.50 per pound after recent peaks above $3 in 2011. The commodity price discount increases profit margins on the expensive cups of Joe that most Americans cannot do without.

Starbucks (Nasdaq: SBUX) has almost doubled from the 2011 lows to the 2012 peak at $62 per share. The rally during the past 52 weeks has seen a 20%-plus price increase even as the stock stalled in July.

Last week's big move up in the stock, more than 4% on Thursday alone, projects a breakout with a $60 target, and then $62, which would push Starbucks to multi-year highs once again. Price support sits at the $45 double-bottom from August and October. A bottom base looks to be in place.

[Related -Starbucks Corporation (SBUX): How Q1 Earnings Will Fare?]

The $62 target is more than 15% higher than current prices, but traders who use a stock substitution strategy could make 70% returns on a move to that level.

One major advantage of using long call options rather than buying 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:

[Related -Chipotle Mexican Grill, Inc. (CMG): This High-Flying Stock Could Tumble 50%]

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 Starbucks trading at about $53.40 at the time of this writing, an in-the-money $45 strike call currently has $8.40 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 Starbucks July 45 Calls at $10 or less.

A close below $45 in the stock on a weekly basis or the loss of half of the option premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $1,000 or less paid per option contract. The upside, on the other hand, is unlimited. And the July options give the bull trend more than seven months to develop.

This trade breaks even at $55 ($45 strike plus $10 option premium). That is less than $2 above Starbucks' current price. If shares hit the upside breakout target of $62, then the option would deliver a gain of 70%.

Action to Take --> Buy Starbucks July 45 Calls at $10 or less. Set stop-loss at $5. Set initial price target at $62 for a potential 70% gain in seven months.

This article originally appeared on TradingAuthority.com:

Coffee Stock's Breakout Could Net You 70% With This Trade

-- Alan Knuckman

Alan Knuckman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of SBUX in one or more of its "real money" portfolios.


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