Hi guys, I wanted to share this blog post I wrote on Lenny Dykstra's deep in the money call strategy:
http://www.longshorttrader.com/2009/04/should-we-be-listening-to-lenny-dykstra.html
Here's the meat of the post:
Lennyâs claim that DITM calls âgive us exposure to a stock with significantly less money at risk vs. a cash or margin purchase for that same stockâ is true if you care about the number of shares you are buying. But he fails to point out that there is a major difference between buying a stock on margin and DITM call options.
DITM call options can easily go to zero if a stock drops 25-30%. If you purchased a stock on margin and it drops, there is still a good chance youâll have something left over, even with a margin call. Of course, thatâs assuming the stock in question wasnât something like Bear Stearns, Citigroup (C), or General Motors (GM).
And by saying your ââ¦your risk on a call position is limited to the cost to buy the option,â he seems to be implying that this isnât a significant risk when in fact it represents 100% downside risk. It is possible to lose more than 100% by buying on margin, but you would most likely receive a margin call and be forced to sell before that happened.
Add it up, and itâs obvious that buying DITM call options is equal to or more risky than buying stock on margin, which Lenny writes off as âa dangerous game.â
Lenny also advocates averaging down on his picks, saying the following in a recent article for TheStreet.com:
Sometimes our prediction is a little off at the outset. Inevitably, some picks will fall further before coming back into their own. And when stocks fall, we turn that to our advantage by averaging down. When the price of a stock goes down, a DITM-option price drops as well. That's our opportunity to buy more contracts at lower prices. I do this in order to lower my average entry price.
"Here's an example. We got the call options in my pick Cisco (CSCO) at an average price of $8.10 a share on Dec. 12, when the stock closed at $16.99. I recommended placing a good-till-canceled sell order $1 above our entry price -- in this case at $9.10.
In mid-January, the stock began to drop. When that happens, my system calls for subscribers to place re-buy orders at specified price levels. When shares of Cisco fell to $15, we bought 10 more call contracts at a lower price. This lowers the average cost of each contract and each GTC order. Because options trade in 10-cent increments, some rounding may be necessary as the price of GTC orders drops."
Essentially, Lenny aims to lock in $1,000 gains, but fails to implement similar limits on downside risk. Throwing good money after bad doesnât make an awful lot of sense to me, especially when the upside potential is purposely limited.
Make no mistake about it, like all unhedged options trading strategies, buying DITM call options carries high risk. And a portfolio of DITM calls is nothing but a leveraged bet on the market, even if you only select the most conservative, well-managed companies. If the market goes down 30%, youâre broke. If it goes up 30%, youâre rich.
Can you handle that without vomiting?
If people fully understand and embrace the risks of DITM calls, then more power to them. I wonât get in their way, but I will present what I view as the dark side of Lennyâs strategy. Hopefully, Iâll help investors make an informed decision as to whether Lennyâs style is appropriate for them.
http://www.longshorttrader.com/2009/04/should-we-be-listening-to-lenny-dykstra.html
Here's the meat of the post:
Lennyâs claim that DITM calls âgive us exposure to a stock with significantly less money at risk vs. a cash or margin purchase for that same stockâ is true if you care about the number of shares you are buying. But he fails to point out that there is a major difference between buying a stock on margin and DITM call options.
DITM call options can easily go to zero if a stock drops 25-30%. If you purchased a stock on margin and it drops, there is still a good chance youâll have something left over, even with a margin call. Of course, thatâs assuming the stock in question wasnât something like Bear Stearns, Citigroup (C), or General Motors (GM).
And by saying your ââ¦your risk on a call position is limited to the cost to buy the option,â he seems to be implying that this isnât a significant risk when in fact it represents 100% downside risk. It is possible to lose more than 100% by buying on margin, but you would most likely receive a margin call and be forced to sell before that happened.
Add it up, and itâs obvious that buying DITM call options is equal to or more risky than buying stock on margin, which Lenny writes off as âa dangerous game.â
Lenny also advocates averaging down on his picks, saying the following in a recent article for TheStreet.com:
Sometimes our prediction is a little off at the outset. Inevitably, some picks will fall further before coming back into their own. And when stocks fall, we turn that to our advantage by averaging down. When the price of a stock goes down, a DITM-option price drops as well. That's our opportunity to buy more contracts at lower prices. I do this in order to lower my average entry price.
"Here's an example. We got the call options in my pick Cisco (CSCO) at an average price of $8.10 a share on Dec. 12, when the stock closed at $16.99. I recommended placing a good-till-canceled sell order $1 above our entry price -- in this case at $9.10.
In mid-January, the stock began to drop. When that happens, my system calls for subscribers to place re-buy orders at specified price levels. When shares of Cisco fell to $15, we bought 10 more call contracts at a lower price. This lowers the average cost of each contract and each GTC order. Because options trade in 10-cent increments, some rounding may be necessary as the price of GTC orders drops."
Essentially, Lenny aims to lock in $1,000 gains, but fails to implement similar limits on downside risk. Throwing good money after bad doesnât make an awful lot of sense to me, especially when the upside potential is purposely limited.
Make no mistake about it, like all unhedged options trading strategies, buying DITM call options carries high risk. And a portfolio of DITM calls is nothing but a leveraged bet on the market, even if you only select the most conservative, well-managed companies. If the market goes down 30%, youâre broke. If it goes up 30%, youâre rich.
Can you handle that without vomiting?
If people fully understand and embrace the risks of DITM calls, then more power to them. I wonât get in their way, but I will present what I view as the dark side of Lennyâs strategy. Hopefully, Iâll help investors make an informed decision as to whether Lennyâs style is appropriate for them.
