Regardless of how long you have been investing, there is always more to learn, new products to understand, altered market conditions to consider, and different investment strategies to suit your changing lifestyle.
Obviously, the main goal of this column is to provide information that enables you to increase your wealth, hopefully in a substantial fashion. Rather than merely providing you with "tips," I believe it is in your best interest to understand the thinking behind the tips. Moreover, recognizing the various vehicles available to you as an investor helps to create lucrative opportunities. To that end, I would like to review my strategy for using deep-in-the-money calls.
Of the numerous emails I receive on a daily basis, unequivocally the most frequent request is for me to explain how to capitalize on in-the-money calls. For many, options remain the most misunderstood investment vehicle out there. But the "buy and hold" days are gone! The sooner you all realize that, the more frequently you will be depositing money in your account! In order to be a winning trader, you have to be willing to change with the times.
Before we get to the nitty-gritty, let me say I relish the opportunity to communicate and interact with you through this vehicle. I am humbled by the large volume of complimentary emails that I have received in support of my column.
I also appreciate, albeit in a different way, the negative emails that I have received, questioning my credentials and my picks. I realize that I am still a rookie, who has to earn respect through sustained performance. Again, I would like to thank
for providing me with this opportunity. I look forward to 2006, where I plan to write regularly about my in-the-money calls strategy, beginning with today's overview.
Understanding the Options
Despite a heightened interest in options, most people do not take full advantage of what options have to offer. By and large, options are considered the ugly stepchild of the investment world. If more investors only did their homework and took the time to understand: This is one of the few areas, you, the retail investor, can find an edge.
If you use and truly understand options -- especially, deep-in-the-money calls -- then you can join the minority of options traders who actually make money on a regular basis. You can become a very wealthy person by just grinding away, finding deep-in-the-money calls where there is very limited downside, with a chance for a whole bunch of upside.
Unfortunately, people who "play" options as a tool for speculation usually get what they deserve. Most people will "take a flyer," and buy an option that is out of the money because they are cheap and it seems easy. They would probably be better served buying a Lotto ticket. (Out-of-the-money calls -- which give the holder the right to buy an asset at a predetermined price -- have a strike price higher than the current market value of the underlying asset. Out-of-the-money puts -- which give the holder the right to sell at a predetermined price -- have a strike price lower than the current market value. For a list of options definitions, please check out the
Options Alerts newsletter.)
Therein lies the reason why most investors lose at options; the majority of volume is short-term, out-of-the-money, cheaper options. In reality, the premium is more expensive and would require almost perfect timing, which leads me to some very important information:
I will be writing only about deep in-the-money calls. If someone sends me an email about any other kind of option, I will have to pass and you should look into TheStreet.com's Options Alerts newsletter, written by Steve Smith.
In order to trade options (or futures), the Commodity Futures Trading Commission (CFTC) requires that a broker provide you with a disclosure document that describes the risks involved, according to the CFTC Web site. You will have to sign the disclosure document before the broker can accept any funds and/or make any trades. I strongly recommend you read this whole booklet, cover to cover, before you trade a single option; if you don't understand what you're doing, you will lose money!
In that same spirit, I strongly suggest you learn about deep-in-the-money calls before you put your money down. I will explain, as best I can, how a deep-in-the-money call works and would like to thank my broker, Paul Hollins of Wachovia Securities, for teaching me the power of options: the ability to control hundreds of thousands of dollars' worth of stock for minimal risk. (Paul is the brother of Dave Hollins, my best friend and former teammate with the Philadelphia Phillies.)
In and Out of the Money
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 said to be 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.
As I have made clear over the last several months in my columns, when it comes to options, we will not be recommending
but in-the-money calls.
The beauty of in-the-money calls is the leverage they provide, which allows you to control a stock with
less money at risk vs. 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.
If you're just beginning, make sure you buy deep-in-the-money calls at least four to six months away from your strike price. If you get the anticipated move, your in-the-money call will capture more of the move. If the stock moves against you, the longer-term option has more time to recover.
My strategy for in-the-money calls is to employ them when companies with solid fundamentals are being (in my eyes) overly punished 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.
Remember, it takes only one or two bounces, or spikes, in the stock for you to make a profit. But you must act! Options can be very volatile, so if you want to be a winning trader, you need to stay on top of your open positions. Remember, 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 you are satisfied with. Don't be greedy, a win is a win, especially in options, because you always have time working against you.
For example, I repeatedly recommended the
April $15 calls, most recently on
Nov. 28 when I wrote:
If you bought 10 of these calls for $3.40 per on Nov. 25, with the expiration date being Friday, April 21, you enabled yourself to control 1,000 shares of Symantec stock at the price of $18.40 (the strike price of $15 plus the option premium of $3.40). Bottom line: For $3,400, you are now in control of 1,000 shares of Symantec until April 21, as opposed to spending $17,640 for an equivalent position in the common stock. What's more, this opportunity comes in a company with a forward P/E ratio of 15.24, $4.43 billion in cash, and $842.7 million in free cash flow. All I can say is, "Lock and load!"
If you followed that advice, you're sitting pretty now as those options settled at $4.45 on Friday. I personally bought 50 Symantec April $15 calls in November for $2.90 for a total cost of $14,500. I sold them at $4.20 on Dec. 4, netting a profit of $6,500. (Remember, an options contract represents 100 shares for one equity option unless it has been adjusted for a special event such as a stock split or dividend.)
Symantec is a perfect example of how deep in-the-money-calls can give you upside exposure to a high-quality stock experiencing short-term weakness.
A second example,
, was a stock I wanted to own. I felt it was oversold and being unfairly punished for the
acquisition. But the price to buy the common stock was (and is) just too high. The only way I was able to participate was because I have learned how to use in-the-money calls.
On Jan. 5, I bought 10 May ConocoPhillips calls at $10.70, which I summarily sold the next day at $11.90, netting a profit of $1,200 in just one day.
For my next trick, which hopefully will also be a "treat," I bought 10
June $40 calls for $6.70 Monday morning. At this price we're only paying 82 cents in premium to control 1,000 shares.
The end result: For $6,700 (the maximum investment, no matter what happens), we are in control of $45,880 worth of stock of the world's largest retailer, all the way until the third Friday in June.
Why Wal-Mart? With a forward price-to-earnings ratio of 15.40, return on equity (ROE) at 22.79%, and free cash flow coming in at $4.8 billion (yes, that's with a "b") we agree with the title of a Dec. 12
article: "Wal-Mart's Still a Bargain."
Given our view that the market will come back to re-embrace this world-class company, we will stick with our game plan and buy deep-in-the-money calls.
Life is a journey, enjoy the ride!
At the time of publication, Dykstra was long Symantec and Wal-Mart calls.
Nicknamed "Nails" for his tough style of play during his Major League Baseball career, Lenny Dykstra was an integral member of the powerful Mets of the mid-1980s, including the world champion 1986 squad, and the Phillies in the early 1990s.
Today, Dykstra manages his own stock portfolio and serves as president of several of his privately held companies, including car washes; a partnership with Castrol in "Team Dykstra" Quick Lube Centers; a state-of-the-art ConocoPhillips fueling facility; a real estate development company; and a new venture to develop several "I Sold It on eBay" stores throughout high-demographic areas of Southern California.