Dykstra: Battered Morgan Stanley, You're Up

With the market looking up recently, it's time to start taking a look at the stocks that have taken a shellacking in the recent market selloff.

The down-and-out company I am eyeing today is a serious bargain: Financial services giant Morgan Stanley(MS Quote), which serves as an adviser to blue-chip companies, governments and investors from around the world, has been hammered beyond belief recently. Some awesome facts:

• $717 billion in assets under management
• Consistent dividend payout growth
• Diversified revenue stream
• Excellent credit ratings
• 58,333 employees worldwide
• More than 600 offices in 32 countries
• Steady earnings growth

Further, this brokerage goliath sports a forward price-to-earnings ratio of 7.66, a return on investment of 25.66% and revenue just shy of $40 billion. Here is the play.

Today I will buy 10 of the January $55.00 (MSAK) DITM calls. I will pay $10.30 or better. I will use limit orders.

Now, as we do every Friday, let's take a look at what you, the readers, have to say.

Hello, Lenny, one question: If I have been able to quickly book a win, and a few days later the price of the option has retreated to (or below) where I first bought it, would it be reasonable to try to repeat the process? In the few days, clearly the fundamentals have not changed, nor has your reason for recommending it in the first place, and I have already completed my due diligence, so it seems like a no-brainer to jump in again. What do you think?

You bring up a good point, Jesse, and I have talked about this before.

If the reasons for a DITM calls trade are solid, a few days of market fluctuations typically won't change that fact. So I will often re-enter a position more than once, scoring multiple back-to-back wins. However, when you make this choice, you are correct that extra due diligence is required. You must make sure that it is market conditions that are making the stock pendulum go back and forth, and not something occurring within the company.

So, by all means, please take advantage as often as you can when good DITM call options plays present themselves. You can be a good trader by following someone else's picks, but you won't become an excellent trader until you can identify a good call and make it on your own.

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Question on your DITM market watch on your Score Card, which as of Aug. 22 consisted of MDR and INFY. I see the note that if the orders are not filled by Aug. 28, you will remove them from the Stat Book. Does this mean you will actually cancel these orders?

Do you have a rule of thumb as to how long you will let a limit order stand, or does it simply depend on how you see things progressing for each specific order?

-- Andy

Yes, I'll cancel the orders. If a DITM calls trade isn't filled, it is because the premium is out of my recommended price range. It has either gone up before I could get in, or other investors are paying too much in premium, and I refuse to chase a stock up -- that's just not a winning strategy.

Also, many brokerage companies tie up cash for open orders, trades that are not filled. This means your cash could be held hostage by a trade you haven't made yet. This is also not a winning strategy. You have to be in the game to win. For the sake of consistency in my column, I will keep orders open during the week recommended, then cancel them the following Tuesday at market close if they are not filled.

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I have been doing a lot of research lately regarding DITM calls and have read many of your articles written about the subject. I understand the basic mechanics but do not understand where the downside protection comes into play -- is it only because of the limited amount of capital? I want to get involved in your strategy but am trying to get some of the missing details. Also, do you ever exercise the options, or are you always racing against time and simply trying to sell them at a profit?

I enjoy reading your columns.

-- Cole

Downside protection using my DITM calls strategy is in the lower amount needed to invest in the world's best companies, but that's not the full picture. Additionally, let's not forget that when we trade DITM calls, we are betting that a stock will have a certain value on a specified date in the future, so we are buying time for the stock to move in our favor.

The typical four-to-six-month purchase also offers us downside protection, because it is rare that a fundamentally strong company will stay down that long.

And lastly, if for some reason we need to roll a position, there is usually a significant amount of capital in the trade we can save by not allowing the option to expire worthless. So, by lowering our initial investment, and controlling our exit, I would say that there is significant downside protection in the DITM calls strategy.

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I am an options novice, and would like to learn more about them. I am curious to know how you decide at what stock price you want to enter a position? Do you go by support/resistance levels? Also, what does "Next level to buy" signify?

-- Dear Shiromani: When I select a company to trade, I look for fundamentally sound companies that are trading significantly lower than they should be. I enter the trade when there is support, as that is the level the stock drops to, but usually resists dropping further.

If the stock does move against me, I will purchase it again at the next level of support. This averages the cost basis of the open play and makes it significantly easier to score a win, as the stock doesn't need to regain all the lost ground; it only needs to move past the average cost basis.