Full Disclosure Finance

By Andrew

Any good investor knows of the numerous options strategies available to them, but few have a strong understanding of how they should be used. There are so many that it is tough to get a good grasp of them all. Options can be very powerful investment vehicles because they provide leverage compared to owning individual stocks. I’ll be the first to admit that my options knowledge is limited. But the goal of this site is for us to broaden our investment knowledge and hopefully educate you in the process. The more weapons you have in the arsenal the better positioned you will be to profit in any market environment. So today I wanted to talk about an options strategy that I do understand. Deep-in-the-money (DITM) calls.

I first read about this strategy in a column by Lenny Dykstra on TheStreet.com…as in three time All Star Lenny Dykstra of the 1986 MLB World Champion NY Mets and 93 National Champion Phillies. A call is said to be in-the-money when the strike price is below the current share price of the underlying stock. If the strike price is above the current share price the call is said to be out-of-the-money. The idea with deep-in-the-money calls is to look for companies with solid fundamentals that have been overly punished for one reason or another. If the decline is overdone or unjustified one can get in-front of the eventual correction by buying the calls at a discount and cashing in as the stock bounces back. Because the calls are leveraged to stock price, any moves in the underlying stock will be captured by the price of the calls. The options are purchased 4 to 6 months out, leaving plenty of time for the required move to materialize. In Dykstra’s strategy he calculates a premium to screen potential purchases. To get the premium for an option you take the strike price for the option, add the price of the call (its premium), and subtract the stock’s present value. A stock with a premium of $1.00 or less is considered to be a good buy. Say for example you found a call option with a strike price of $24 for a stock that was currently trading at $27.50. This means that you would be willing to pay up to $4.50 for that specific call option ($24 + $4.50 - $27.50 = $1.00). Once you find a stock that meets these requirements a good-till-canceled (GTC) limit order is placed for 10 options at the target price. Options can be very volatile so to be successful in this strategy you need to stay on top of your open positions and lock in profits when you have them. Once the order has filled you can place another good-till-canceled limit order at $1.00 above the purchase price ($5.50 in the above example). If the stock moves and the call price goes up by $1.00, a profit of $1000 is locked in by the automatic limit order. In our fictitious example above you only need to put down $4500 to purchase the 10 calls, but because each call represents 100 shares you are actually controlling 1000 shares of the underlying stock. The capital required to purchase 1000 shares of the common stock would have been $27,500. This is called leverage. By putting down $4500 and locking in the $1000 profit you are leveraging the underlying stock for a 22% gain.

Let’s look at a real world example. Microsoft Corp. (MSFT), along with many of the other big cap tech stocks, has been on a slide since the beginning of the year. It was a $37 dollar stock as recently as November, but has gotten punished along with the rest of the market. It has recovered slightly (closed March 25th at $29.14) but is still at a significant discount, trading at 16.58x trailing earnings and 13.88x forward earnings. The company’s past two quarterly earnings announcements have been stellar and there is no reason to believe that trend won’t continue through 2008. The July 2008 $24.00 calls (MSQGD.X) are currently priced at $5.90, which gives us a premium of $0.76 ($24 + $5.90 - $29.14 = $0.76). Going out to July gives us 4 full months to get the required bounce in the share price. To utilize this strategy we would place a good-till-cancelled limit order for 10 of the July $24 calls at $5.90 (requiring a capital investment of $5,900). Once the order fills we will immediately place another good-till-cancelled limit order to sell the calls at $6.90. If we get a move in MSFT that boosts the call price to $6.90, the order will automatically execute to lock in our $1000 gain (good for 17%).

I’ll keep you posted on how this pick works out as well as any other opportunities that I stumble across.