Lenny Dykstra's Deep in the Money Calls

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:

Lenny’s claim that DITM calls “give us exposure to a stock with significantly less money at risk vs. a cash or margin purchase for that same stock” 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 you’ll have something left over, even with a margin call. Of course, that’s assuming the stock in question wasn’t something like Bear Stearns, Citigroup (C), or General Motors (GM).

And by saying your “…your risk on a call position is limited to the cost to buy the option,” he seems to be implying that this isn’t 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 it’s obvious that buying DITM call options is equal to or more risky than buying stock on margin, which Lenny writes off as “a dangerous game.”

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 doesn’t 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%, you’re broke. If it goes up 30%, you’re rich.

Can you handle that without vomiting?

If people fully understand and embrace the risks of DITM calls, then more power to them. I won’t get in their way, but I will present what I view as the dark side of Lenny’s strategy. Hopefully, I’ll help investors make an informed decision as to whether Lenny’s style is appropriate for them.

 

I think you know what you are talking about. I could hardly believe it when I first saw how low of targets per trade Lenny was targeting! Trying to make $1 per contract while risking a large number of $s per contract just doesn't make sense to me.

When I first read some of his articles I admit I was a bit intreged by his idea in general - buy DITM calls only on quality stocks, but the overall market can stay low for too long (as we've seen) and taking profits so quickly would ruin the occasional big rally profits.

I think that some of Lenny's ideas can make sense if the stock is never going to go to 0 and stay there, if a person can afford to keep buying more and more calls as the price falls, and even then I would add that this investor would need some large gains to offset any losses, but by taking profits so quickly, that is unlikely (the only way then is if the stock gaps way up therefore causing the options to gap way up and earning more then $1 per contract).

Of course, with any common stock if it's not going to $0 and you dollar cost average all the way down and then get a huge rally, you will also win that way as well, so I don't think Lenny's call buying gives a person any edge.

JJacksET4

 

0:7 , wow ! You all checked the incorrect answers, including OP ( he should of make another , third choice). Let me ask you : if Lenny system sucks , what stopping you from taking another side of his trades ? According to you its an arb , lol

 

not this again...why dont you just do a search for lenny dykstra.

That's incorrect thinking. The stock is $100, the ditm call is $50. Controlling 100 shares in each case.

1) If the stock goes to 0, you lose $10,000 if owning stocks, and lose $5,000 if owning ditm calls. So risk is smaller.

2) If the stock goes to $50. You lose $5,000 owning the stock, and you lose $5,000 owning the ditm calls. Ok so you still have the 100 shares left if buying the stock? well you saved $5000 when buying ditm calls, can use that money to buy the same 100 shares at that time for $50 each. So there is no difference.

The disadvantage of owning ditm, is the same as owning any options vs stock, your delta is <1 (less profit), you pay premium, and has theta to worry about. The deeper in the money the closer it mimics a stock, but you also risk more capital.

 

I agree with this of course, but let's face it - alot of people to try gain leverage would spend $10,000 on the stock or $10,000 on the calls (doubling the shares controlled). So, you can now lose $10,000 either way.

And, using Lenny's sell for any gain rule, you would barely get any gains even if the stock moved in your direction, therefore making the leverage less useful anyway!

IMO there are much better ways to invest then following him - if someone wants to follow him however, that's fine with me.

JJacksET4

 

Just keep averaging down. Works every time. Well, almost every time. He "lost" (apparently he doesn't really trade his recs) more than $200K on Amdocs:

http://www.elitetrader.com/vb/showthread.php?s=&postid=2286153&highlight=Lenny+Dykstra#post2286153

 

You're confusing risk in terms of dollars lost with percentage of dollars risked.

 

When comparing risk, you don't compare 100 shares with 200 shares (or option equivalent). If you're going to do that, you could just as well compare 132 OTM long calls to 100 shares.

 

I don't think his strategy makes any sense. First of all, seems like a terrible risk/reward. Taking only a 1.00 per trade profit, then averaging down when losing? How much does he lose when the averaging down does not work? I would be many X the 1.00 profit he makes. Personally, I do not know how anyone can make it averaging down. Turning a loser into a mega loser would really depress me as a trader. Why become so attached to a trade? I say catch the next bus. Seems suicidal to me. Maybe if you have amazing discipline, it could work for you.

Oh yeah, must not have worked to well for him. Seems like he is losing everything right now according to this article

http://www.nypost.com/seven/04062009/news/regionalnews/lienny_dykstra_163150.htm

 

Spin,

I agree. I agree. I agree. However, people will view it like this - if 100 shares is "risky", but a DITM call is "safer" (due to Lenny's claims for example), they will think they can just buy 2 DITM calls then - as it's the same cost anyways (in the examples given).

I don't consider 100 shares or 1 DITM call or 2 DITM calls to be safe per se - all 3 can go to 0.

JJacksET4