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Dykstra: Limiting Downside Risk

Lenny Dykstra

Baseball teams without the New York Yankees' deep pockets are haggling not just over how many millions to shell out for free agents this season. As always, contract length is a significant factor.

After Jason Giambi made $23.4 million during his final year with the Yankees, the $4 million he took from the Oakland Athletics Wednesday may not be the most disappointing aspect of his deal. The veteran designated hitter's contract allows the team to buy him out the following year for $1.25 million.

Faring a little better, starting pitcher Derek Lowe has been offered a three-year deal with the New York Mets that would pay him $36 million. And the Chicago Cubs are believed to be picking up switch-hitter Milton Bradley for $30 million over three years. But most free agents have little option other than one-year contracts because teams want to limit their downside risks.

In free-agent negotiations, teams may want to lower the risk that the player won't live up to his record, or worse -- will suffer performance-limiting injuries. On the other hand, players want to maximize both deal size and length -- and for the same reasons. Players also worry about injuries and want to lock in long-term salaries.

Investors can limit downside risk in options contracts as well. While they don't have to worry about injuries, investors do need to make sure they aren't exposing themselves to massive losses. My deep-in-the-money (DITM) options trading system -- which has a phenomenal winning record -- limits downside risk. That type of risk is an issue that comes into play in today's question from a reader.

Q: Can you explain the difference between a "buy to open" and a "sell-to-open" order?

A: There are several ways to buy and sell stocks and options. You can buy a stock and sell it later; and you can sell a stock and buy it later, which is called shorting the stock. The same works with buying and selling options.

My strategy calls for buying options, then selling them later. These orders are placed using a "buy-to-open" limit order.

Now let me explain the difference. When we buy a call option contract, we are essentially paying for someone to guarantee to sell us the stock at a set price and on or before a set date. Then when we sell the contract, we are giving someone else the right to buy the stock. That is our strategy, and it limits our risk to the amount we paid for the option.

However, if we sell an option as an opening order, we need to either own the stock or have the ability to buy it. In "covered call writing," which is used as a hedge against falling stock prices, you sell options and own the stock.

Most option contracts sold are written by covered call writers. When you use this strategy, your risk in the trade is that the stock will be called away, in which case the option buyer will exercise the contract and you will be required to sell it. To avoid having your stock called away if the stock price goes up, covered call writers will buy another option contract to cancel out the first order, taking a loss in the premium difference.

Selling an option as an opening order without owning the underlying asset is termed "naked call writing." This is a high-risk strategy because you are guaranteeing to sell the stock to the contract buyer. If someone exercises the option, you will have to buy it, regardless of the stock price. Your risk in this trade is unlimited. No matter how high the stock goes, you may have to buy it and sell it at the strike price in the option contract.

My DITM options trading system, which you can learn about through my Nails on the Numbers newsletter, has given me a winning streak of 94-0 with my payout this week from my call on Corning(GLW Quote). Other recent wins include Cisco(CSCO Quote), Texas Instruments(TXN Quote), Microsoft(MSFT Quote), Halliburton(HAL Quote), Garmin(GRMN Quote), Dow Chemical(DOW Quote) and Applied Materials(AMAT Quote).

Lenny Dykstra manages Nails on the Numbers, a subscription service sold by TheStreet.com. Mr. Dykstra is 94-0 in his options picks. Click here for a free trial to Nails on the Numbers. Mr. Dykstra writes regularly about options trades for TheStreet.com.