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Dykstra: Deep-in-the-Money Calls 101

Lenny Dykstra

06/24/08 - 09:24 AM EDT

When I played ball, I tried to find an opening, a weakness, in my opponent and take advantage of it. That's the goal of any ballplayer worth his salt.

When you boil it down, my outlook on investing is pretty much the same. I try to find good companies that the market has valued incorrectly and take advantage of this discrepancy.

I've developed a successful and straightforward strategy that isn't overused in the marketplace: deep-in-the-money options calls. I've been writing my columns for TheStreet.com for a few years now, and the number one question I get from readers is about my approach. So, in today's column, I am going to walk you through my approach because it's just as important to understand the reasoning behind my picks as it is to understand the picks themselves.

Using deep-in-the-money calls allows you exposure to the best companies in the world at a fraction of the price of the common stock. Readers of my columns will know that when it comes to options, I will not be recommending anything but in-the-money calls.

Mad About Options: Dow Chemical

If more investors did their homework, they would realize deep in-the-money calls are one of the few tools that can help you, the retail investor, find an edge. However, options can be very volatile, so if you want to be a winning trader, you need to stay on top of your open positions.

Through my subscription newsletter, Nails on the Numbers, I will do my best to help put you in position to ring the register over and over again. (Click here to sign up for a free trial or a subscription.)

If you don't have the time to watch your stocks all day, you can always put a good-till-canceled (GTC) limit order in to capture the profit. Remember, a win is a win, especially in options. Don't be greedy, and keep in mind that with options, you always have time working against you.

To help you get started, here's the CliffsNotes version of DITM calls.

  • The strike price, or exercise price, of an option determines whether that contract is in the money, at the money or out of the money. If the strike price of a call option is less than the current market price of the underlying security, the call is in the money; the holder of this call has the right to buy the stock at a price that is lower than the price he would have to pay to buy the stock in the open market.
  • I love in-the-money calls because of the leverage they provide. It allows you to have exposure to a stock with significantly less money at risk versus a cash or (certainly) margin purchase for that same stock. Your risk is limited to the cost of the in-the-money call, compared with buying the stock with cash or on margin, which is a very dangerous game that I strongly suggest you avoid playing.
  • My deep-in-the-money calls are normally at least four to six months away from the strike price. If the stock moves in the direction I expect it to, my in-the-money call will be in prime position for a win. If the stock moves against me, with the DITM call, I have more time to recover. (I will explain more about averaging down, an important part of my strategy to manage a pick that goes down, in a future column)

To sum it up, my strategy for in-the-money calls is to use them when a solid company is being beaten down on Wall Street for one "transgression" or another. My theory is that this overreaction will eventually correct itself as the value of the company reasserts itself over time; those who buy deep in-the-money-calls in advance of this correction will be rewarded.

All it takes is one or two bounces, or spikes, in the stock to make that profit.

Remember: Life is a journey, enjoy the ride!

Brokerage Partners