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Dykstra: Why I Buy Deep-in-the-Money Calls

Lenny explains his strategy and fields reader email.

With the market looking to tank this morning, I want to take this opportunity to drive home the power of deep in-the-money calls as a "stock replacement" strategy.

I buy deep in-the-money calls as an alternative to the outright purchase of common stock so that I can capture the bulk of a stock's move in a shorter time frame. True, buying at-the-money or out-of-the-money calls requires less money, but that's the trap, because they offer less leverage.

I buy DITM calls that won't expire for four to seven months. The leverage these DITM calls provide is remarkable. When one compares downside protection with the upside rewards, I consider it comparable to the Mets playing a high school team.

Far more often than not, in buying sound companies, the sell prices are hit long before the strike date. In the recent bearish action, the market has killed stocks indiscriminately. Companies that have strong, sound profits have lost market capitalization at a similar rate to mostly speculative companies trading at bloated

price-to-earnings ratios. Those are the sort of companies that will perform well using my strategy.

Now we will take a look at the reader's emails, as we do every Friday.

What do you do when expiration is twodays away and the price is way belowyour purchase price? You must have astrategy to deal with that, but you seemto claim no losses.

When an option is close to expiration, there are three choices investors can make: Exercise the option and purchase the stock, allow the option to expire, or sell or roll the option for a loss.

The strategy I implement with my deep in-the-money calls is to buy with a strike date four to seven months in the future in order to provide leverage and downside protection over a long period of time. More often than not, in buying sound companies, the good-till-canceled sell price will hit long before the strike date.

However, on the rare occasion when this has failed to occur, we adapt the strategy. On Tuesday, this was the case with the August $42.50

Bank of America

(BAC) - Get Bank of America Corp Report

calls. They had only 10 days until expiration, and the position was underwater.

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I elected to roll the position into the November $40 Bank of America calls and book a loss to the Stat Book. This move was the prudent choice, because it preserved $46,400 in capital, which would have been lost if the options were allowed to expire. It would have taken about $340,000 to purchase the shares of stock I controlled outright -- a pricey choice, and not a strategy I would recommend.

Moving the capital into the November position allowed me three additional months to capture a gain with Bank of America, a company so consistently profitable that it holds a 30-year record of consecutive quarterly dividend increases. Within two days of this move, the Bank of America November $40s closed out for a win.

Thanks for your advice and strategies. It is certainly a different approach.My question is, with your BAC move yousold BAC calls for a loss and thenbought more further-out calls. Wouldn't that be considered a wash sale?

When a security is sold for a loss and a like purchase is made within 30 days of the sale, (either before or after the sale), a loss cannot be claimed on the losing position. However, the loss can be transferred to the cost basis of the like security item.

This means that for income tax purposes, the loss of $11,200 on the Bank of America $42.50 would really increase the cost basis of the November $40s that were purchased. When the November $40s were sold, the loss would be inclusive of the sale. For simplicity's sake, I have listed the August loss as a separate entry to show the transaction closed and the effect it had on my win/loss total to date.

For example, say you bought 10 contracts of Option A for $1,000 and sold them for $750, producing a $250 loss. Ten days later you buy 10 new contracts of Option A for $800. Because they are identical securities, you can't immediately take the loss.

But you can add the disallowed $250 to the $800 price of the new contracts, producing a cost basis of $1,050 for the new contracts. When you sell the reacquired options, the adjusted basis will, depending on the sales price, produce a bigger loss to claim or reduce any taxable gains.

Hi Lenny. Welearned a lot from your BAC rollover lesson. Ourquestion is that you said you could write off $11,000 intax loss ... our understanding is that you can only writeoff $3,000 maximum loss per year ... has that changed,or is it different for options?P.S.: Are you Dutch?

It's important to remember that losses and gains must be combined together to determine whether you will have a net loss for the year. So, if you have a capital loss of $11,000 and a capital gain of $12,000, then the net gain for the present tax year would be $1,000. You can ignore the $3,000 limit on losses per year, because you have an overall net gain of $1,000, in this example.

In other words, the $3,000 limit applies only if your total net loss for the year is over $3,000, after any capital gains have been added. If the net sum of gains and losses is no worse than $3,000, then you can claim all the losses in the current year.

If the net sum of gains and losses in greater than $3,000, you don't lose the expense; you will just need to carry it forward to the next tax year as a net capital loss carryover, which can be used in increments until completely accounted for.

For a more detailed explanation of capital losses and the benefits of loss carryovers, please consult your income tax professional.

At the time of publication, Dykstra was long BAC.

Nicknamed 'Nails' for his tough style of play, Lenny is a former Major League Baseball player for the 1986 World Champions, New York Mets and the 1993 National League Champions, Philadelphia Phillies. A three time All-Star as a ballplayer, Lenny now serves as president for several privately held businesses in Southern California. He is the founder of The Players Club; it has been his desire to give back to the sport that gave him early successes in life by teaching athletes how to invest and protect their incomes. He currently manages his own portfolio and writes an investment strategy column for, and is featured regularly on CNBC and other cable news shows. Lenny was selected as OverTime Magazine's 2006-2007 "Entrepreneur of the Year."