(Ed.: This article contains graphic depictions of what can happen to you if you screw up in options. It is not meant for children, or for the squeamish, and could be extremely hazardous to your financial health if abused in any way. Really.)
The raw power of options fascinates me. The idea that I can control so much stock with so little money amazes me. Winning at options makes you feel like you're a major-leaguer. An options home run outshines any 440-footer over any left centerfield wall in any stadium in the country.
And an options wipeout? Remember the handoff in the Miracle in the Meadowlands? Remember the pitch
belted out of the park to win the World Series in '94? Remember the ball
stole to beat the 76ers? (Man, you are old.) When you get crushed in an options trade, you know what it feels like to have been on the wrong side in all three of those nightmares.
That's why I am glad you have come to my couch/trauma center. I have probably wiped out more options than anyone alive. I have destroyed capital in puts and calls with Warp 10 speed. I have been vaporized, disintegrated, obliterated and decimated as surely as if I were picnicking in the mountains of Monserrat.
Yet, I am here to tell you about it.
And I will do it again today.
Because I win more than I lose. Because I have discipline. Because I know how to limit my losses. Because I know how to trade.
Today's session will deal with two rules that get broken everyday by crummy traders who would do better to take their life savings and email them to those middle-level marketing scammers who flood my mailbox everyday.
First, typically, you should not use out-of-the-money option calls unless you have so much money that you want to help your poor starving broker. What looks cheap, what looks seductive, is probably worthless. If you have a good idea, and you want to leverage it, use in-the-money calls as a proxy for common. The out-of-the-monies will vanish come that third Friday of the month and you will be left with the worst of all possible worlds: You will be right and lose everything.
But if you use in-the-monies you can magnify your return just fine. Don't get me wrong. I listed the pantheon of sports goats to inflict vicariously the pain you will feel from the financial loss if the underlying stock takes a sudden nosedive on you -- because that will also crush your in-the-money calls. Those who think I am abetting use of options, forget it. Stay away. I am only preaching to those who understand the uses and risks and keep playing anyway.
But there is one time when out-of-the-money calls are the ideal conservative weapon in your arsenal. We find at our shop that during -- not after -- a dramatic decline, bargains can be had when betting against the trend. Let's talk about one of my biggest hits of the year. When everyone was running around wishing that
during the horrendous selloff for the networker this spring, all of my work told me that if Cisco got it right, the stock would bounce right back and then some.
As I already owned a lot of Cisco, I was way too leveraged to the name to buy any more. If I was wrong -- which happens incredibly often to me but to no other investing professional I know -- I would have been crushed beyond recognition. With the stock hovering in the high 30s, the Cisco 50 calls out about six weeks were trading at about 5/8ths of a dollar. Now there's a risk/reward I could live with. If Cisco made the quarter, that contract could be worth a fortune. If it missed, I'd feel some pain, but nothing that would send me to Payne Whitney.
So I took down as many as I could, so many that both
did stories about this purchase. It made me laugh because for me the amount of capital was very little. If I had blown up, I would not have missed that money. However, had I attempted to buy that much common and been wrong, I would have had to write a letter to my partners explaining how stupid I was.
Well, we all know what happened. Cisco pulled it off and the stock blew through that strike and the two above it by options expiration, and I had hit the grand slam with two out in the ninth in the seventh game of the World Series.
So, what's our lesson here? Quite simply that in-the-money calls should be your weapon of choice if you want to leverage -- AND IF YOU UNDERSTAND THE PAIN THEY CAN ENTAIL TO YOU FINANCIALLY IF YOU ARE WRONG. But during a big down move, when all seems lost, that's when you should be scanning the out-of-the-money calls for premium-shrunk bargains. That's when you will be competing head-to-head against me for the 5/8ths-of-a-dollar gems. That's when they are worth their while.
James J. Cramer is manager of a hedge fund and co-chairman of
. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Mr. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he welcomes your feedback, emailed to
This story was originally published on Aug. 29, 1997.