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Lenny Dykstra - Deep In-The-Money Options Strategies - Who Took My Money?

Posted by Pete Stolcers on May 2, 2009

In today’s option trading blog I’ll field a question that was forwarded to me by my friends at TradeKing. They have an extensive blog community and it’s a great source of trading information. In the process of answering the question, I’m going to teach you how to save hundreds of dollars (thousands if you’re trading Len Dykstra’s size) when you are getting out of a long option position that is deep in-the-money. Let’s get started.

This excerpt is taken from the middle of an article posted in Fortune Magazine. It describes Mr. Dykstra’s approach to option trading. “All I need is one uptick. I can lose only if there’s an accounting scandal I can’t control,” he says. To illustrate how it works, he sent me trade executions where he bought 100 calls of Anadarko Petroleum (Charts) on Nov. 7, when it was trading at $47.28, with a December $40 strike price. He paid $7.40 a share in order to control 10,000 shares, putting up a total of $74,000. On Nov. 9, when Anadarko bounced to $48.90 a share, Lenny sold his options and made roughly $5,000.

Something was off in the calculation of the profit and one of TradeKing’s customers asked for clarification from the Fortune Editor. This is Andy Kirk’s letter to the Editor: “In your article on Lenny Dykstra, you cite an example of 100 calls trading at $47.28, with a strike price of $40. It cost him $7.40 a share to get control of 10,000 shares, and he sells them later at $48.90. You say he made roughly $5,000. I don’t understand your figures. I have him making $15,000 profit: ($48.90 – $40) x 10,000 = $89,000 – $74,000 = $15,000. What am I doing wrong?”

At this stage, I’m reading along thinking that the Editor would respond to Andy and say that a typo was made and that the stock was actually at $47.90 when Len Dykstra sold the calls. At that level, they would be intrinsically worth $7.90 (the stock price of $47.90 less the strike price of $40) and a half a point profit times 10,000 shares would make $5000. After-all, Len himself states he’s only looking for an uptick. That’s not what Andy heard back.

Here’s the Editors response: “You’re measuring the gain in the stock price, not the gain in the options price. Dykstra never owned the stock itself, because he never exercised the options; he traded them, like stock. Dykstra purchased 100 Anadarko options for $74,000. When the stock price increased, so did the options price, but by a lesser amount, and he sold them for a profit of roughly $5,000.”

Oh boy! That was a rather flippant, spontaneous response and the Editor is not giving his reader much credibility. He answered the question without even thinking about it. At a glance, any option trader could see that there was a mistake. If the stock was truly trading at $48.90, there is NO WAY Len would have been filled at $7.90. The auto quote systems used by Market Maker firms are set up so that they move in tandem with the underlying stock. In this case, the firm’s proprietary algorithms would identify how many shares could be immediately executed at a particular price and they would establish a bid on the calls just under that price. As the bid and bid size of the stock changes, the auto quote adjusts. On deep front month options here’s how it works. Let’s say that the bid/ask on the stock is $48.90, x $48.95 for 1000 shares on both sides. The auto quote option bid/ask will be somewhere below and above that market, let’s say $8.80 x $9.00. If there are 50,000 shares of stock bid at $48.85, the auto quote will be bid for size at $8.80 and here’s why.

As soon as Len would enter his order to sell 100 of the Dec 40 calls, he would get filled at $8.80. In an instant, the proprietary Market Making firm would electronically hit the stock bids and sell the stock. They would sell 1000 shares at $48.90 and 9000 shares at $48.85. They don’t have to wait for an uptick to sell the stock because they are long the calls with the intent to exercise them. Here’s what they would make. Through exercise they bought 10,000 shares at $40 and they sold 1000 shares at $48.90 and they sold 9000 shares at $48.85. They paid $8.80 for the calls so their P&L looks like this. 1000×8.90 plus 9000 x $8.85 less 10000 x $8.80 (100 contracts equals 100 shares). They made $100 plus $450 or $550 in an instant. This my friends is called arbitrage and it is what Market Maker firms do. In reality, there’s a chance that if they felt they were able to sell the stock short on an uptick, they would “work” the stock sell orders and not exercise their calls. The reason for this is that they have virtually a risk free position (the stock is $8.00+ in-the-money) and they can collect credit interest on the proceeds of the short stock sale. Before you get too excited, retail customers do not collect credit interest on short sale proceeds. It’s not offered by brokerage firms unless you are a HUGE trader. The short stock long call position also assumes that there is not a dividend due over the holding period.

The bottom-line is that the Editor should have read the question and given his response due deliberation. Hey, we all make mistakes and I’ve found Fortune to be a good read. Here’s why his rationale was inaccurate. Only in an instance where someone is holding an deep in-the money option that is priced with a lot of time premium can the delta of the position be less than 1. The options were already trading at parity ($47.28 less $40.00 = $7.28 and he paid $7.40) and it is unlikely that condition changed on an oil stock during the 2 days the position was held. If the condition did change, the implied volatility was already at zero and it could only go up, making the options worth even more. If the option didn’t move point-for-point it would have set up an arbitrage situation. The whole world would have bought the calls from Mr. Dykstra at $7.90 and sold the stock for $48.85.

Who took Mr. Dykstra’s money? No one. If he made $5000, the stock was at $47.90 and Andy was spot on in noticing the typo.

This brings me to my next point. How can you get the most out of an in-the-money long option position going into expiration? Let’s use the example above. First of all, always remember two things: 1. The stock is much more liquid than the option. 2. The option gives the holder the right to exercise. In this particular case, your first action is to sell 1000 shares of stock at $48.90. The next step is to consider that there are 50,000 shares bid at $48.85. There are many more shares bid than the 9000 you have left. Place an order to sell another 1000 shares at $48.90 and keep entering the orders until you are filled. If the $48.85 bid starts to disappear, hit it. Let’s say that you get all of your shares filled at $48.90. That is effectively the same as selling the calls for $8.90 – a dime better than the $8.80 bid. On 100 contracts, that’s an extra $1000. In Len Dykstra’s case, I hope he knows this trick. He is giving up too much of an “edge” if he sells the calls to the Market Makers. I don’t know about you, but I have no need to line their pockets.

There are a couple of other items left. You need to contact your broker ahead of time to discuss getting out of the trade and to find out how the situation is handled at their particular firm. It is standard that they take the exercise notice and make you long the corresponding number of shares in the account. In doing so you can sell the shares without an uptick. This whole process is recognized by the exchanges and the OCC as a sort-exempt transaction because you are effectively long the shares of stock. You must make sure you sell the stock because the brokerage firm will enter your exercise request and you will come in long shares the next day. You will also have a giant margin requirement. If you do this all the same day, it is called a “same day substitution” and you don’t have to meet the stock margin requirement. The second point is that you will have an extra commission since you are selling stock and exercising an option. Big deal! Have you seen TradeKing’s commissions? If you sold 1000 shares at a time it would cost you an extra $49.50 (10 x $4.95) to make $1000.

If you want to look at this exit method using another example, read, “Avoid the Option Expiration Rip Off”.

As always, please share your comments.

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Option Trading Comments

  • On 01/27, Born2Code said:

    interesting read, lots of great information.

    i am not sure about TradeKing, but it seems to me that the commission at other brokerage firms would add to the cost quickly. For instance, i know Ameritrade charges something like $35 if the contract is exercised. They would also charge you separate ticket commissions for each 1000 share block you sell instead of one ticket for the 10,000 shares if sold together.
    i would also imagine that if i am on the phone with them trying to exercise the options and sell the shares then they are going to charge me the “phone” commmission and not the on-line commission.
    i would imagine the bigger the account size the easier it would be to negotiate all that stuff and reduce the cost.

  • On 01/28, Pete said:

    Your comments bring-up a great reason why most people don’t take this route. There are some “unknowns” that need to be worked out. Once they are defined, it’s smooth sailing. First of all, before the situation even comes up, you ask a Registered Rep. on the order desk to walk you through the process (call during non-market hours and you’ll get more attention). Tell them exactly what you plan to do. Then ask for the policies. Don’t settle for some half-baked answer, go to the top if need be. Write that person’s name and number down. When the situation arises, you want to have everything in order. The excercise notice should be a flat charge for the whole thing. Remember, you will have to pay option commissions if you just get out of the trade anyway. In this case, you’ll have those same charges plus an exercise fee. Ameritrade charges $29.99 and TradeKing charges $9.95. There’s no need for broker assitance. Most firms have an exercise button built right in. Bottom-line, even with Ameritrade it will cost you $29.99 to make an extra $1000!

  • On 01/28, Jeffrey Komisar said:

    Interesting topic. I always enjoy reading your blog and learn something from each.
    I assume one cannot use this strategy if the deep in-the-money call options are in an IRA account since shorting is not allowed. Is that correct?
    Thanks Pete

  • On 01/28, Pete said:

    Each brokerage firm determines which option strategies they will allow their customers to use. Almost all of them allow option purchases because the risk is limited. If the number of in-the-money calls equals the number of shares you intended to purchase the position can be less risky than owning the stock. The options can go to zero, but the stock can drop much further. In this example, Lenny had the same upside as the stock but his risk was limited to the $7.40 he paid for the options. If the stock dropped $20, he would lose less than if he owned the stock. The pitfall is that traders leverage up and they buy more contracts than they would shares. Leverage is a double-edge sword that cuts deep. The method for getting out of the call can be used in any account type since you are never short the stock. You are merely converting the options to shares and selling the stock.

  • On 01/28, Born2Code said:

    Jeffrey, my understanding is that there is no shorting involved. You exercise your option, thus you own the stocks, and then you go ahead and sell it. Also, my IRA accounts allow for only covered calls, so i do not think you can go long the deep ITM calls to start with.

    Pete, thanks for the info. I am new to the site and i went back and read some of your older postings and the ActiveTrader article. All great stuff. Thanks for sharing all that.
    I have another comment/thought. You talk about people attempting to make 0.5% daily with a $100k account, and you explain why you do not buy into that idea. My question/comment is this: isn’t buying deep ITM calls and waiting for an “uptick” the same as trying to make the half a point day trading? Other than the leverage factor and the different time frame, it is pretty much the same concept!
    my point is that while it may sound easy, it suffers from the same drawbacks.

  • On 01/28, Jeffrey Komisar said:

    Thanks for your responses. Born2Code - if you want to do more than covered calls in your IRA you might want to look into OptionXpress or Thinkorswim as these firms allow you to do many more option trades in IRA’s including long calls and puts, credit and debit spreads, and cash-secured put selling.

  • On 01/28, Pete said:

    Great comment. The shorter your time frame, the more inclined you should be to trade the stock. It is MUCH more liquid and it can be scalped. Your slippage goes way down and you are not at the mercy of the Market Makers. Often, they are the only ones you are trading against and there is no way to middle a trade. They simply won’t budge on their markets. They may even back away from your bid/offer once they see it. There are so many months and strike prices that the order flow is spread out. The stock on the other hand is very tight and it has one very “thick” bid/ask with lots of eyes focused on it. Anytime you are day trading, your risk and reward will be lower and you will work VERY hard for what you make. The trading is not very scaleable since there is only so much size you can get in and out of in a day. S&P;500 and other futures products are the exception. In Len’s case, he held the options two days (overnight), he traded a liquid stock, and not he had a high delta. If he was only looking to make a half a point, I would take issue with the trade. He is taking to much risk for that reward. If he was looking to make $2 and didn’t like what he was seeing and got out - no problem. In fact, he may have made $1.50 if the stock was at $48.90. Something was off and we don’t know if it was the profit calculation or the stock price.

  • On 01/28, Born2Code said:

    Jeffrey, thanks so much for the tip. I had always thought it was an IRS rule that you can only sell covered calls in your IRA account. This is valuable information, and i am glad the subject came up. Thanks again.

    Pete, thanks for the feedback. for now, i am going to stick with stocks and the occasional slightly ITM front month option trade.

  • On 04/25, Pete Stolcers said:

    test

  • On 05/25, Arvydas said:

    Lets revert to Lenny?s trading. I check a lot of his recommendations on TheStreet.com and found something that contradicts with recommendations from few books of professional traders, which I would consider as reliable sources. First of all is the simple rule: ?the trend is your friend? and from that: ?don?t play against trend?. One of samples - on today?s (May 25) Lenny?s article I found recommendation to buy Komag (KOMG) DITM calls. I check chart of this stock and found clear bearish trend during last 6 months without any serious sign about reverse- just pure drop from $41 till $23. Maybe Lenny may say that this stock was ?beaten-down and oversold?, so it?s ?time to grab calls?, but is there are not possibility that it will go down till $10 and more. Or just stay there and time will grind your premium. Somebody may say that it?s not possible, but: ?Wall Street is covered by bones of traders, which last words were: it can?t be true?. Also, according to other sources: ?Don?t try to guess the trend- trade what you see?. Moreover, if the stock will continue his way down Lenny recommends buying more calls, which became cheaper (what a luck). In such case you reducing your price (?averaging? between old and new price), but from other side your position increasing a lot, also you risk is increasing a lot too. According to point of view of other traders ?averaging? is the tactic used by: a) rich traders, b) foolish traders, c) both a and b in one. From that is other strict rule: ?if the market going against you- don?t average your position. Don?t afraid to take little loses before they became huge and kick you out of the market?. Also, according to pros such trading against the trend with averaging of price is considered as ?cowboy?s shooting on flying targets? and ?soon or later on your gravestone will be wrote: here is lying (your name)- he was fast shooter, but somebody was faster?. BUT if you will check Lenny?s Stat Book (updated each week) you will find that he wins almost every week. I?m confused- maybe all I quoted isn?t right and it?s really ?time to grab calls?? Or it was just lucky days of bullish market. I don?t know, but one of the sentences I quoted belongs to some guy named Warren Buffet- maybe he was wrong?..

  • On 07/16, Bill said:

    has any one out there have Dystras up to date stat book I am looking into his system and need a up to date stats.......??

    thanks..

  • On 07/20, George said:

    He updates every Wednesday.

  • On 10/30, Eyal Soha said:

    The autobid described can (and actually does) better than what you described.  Assume the call is deep-in-the-money and expiration is in one year (to make the math easier).  In your example, the stock’s bid/ask is $48.90 x $48.95 and the calls are $8.80 x $9.00.  I can buy 1 call and sell 100 shares for a net of (4890 - 900) $3990 (not including fees).  In one year, I exercise my option and give the stock back to the broker for $4000.  A total loss of $10.  BUT…

    I just got a one-year, 3990-dollar loan from the Market Makers for $10!  That’s a rate of 0.25%!  I could put that money into T-bills and make around 4% guaranteed.

    The Market Makers already did that math and the bid for the option takes it into account.  You can calculate the loan rate that you’d get from the options and it works out to around 5%, depending on the current rates at the Fed.  TANSTAAFL.

  • On 10/30, Pete Stolcers said:

    Hi Eyal,

    Absolutely the auto quotes are configured to incorporate interest rates. My point was to illustrate why the options have to trade at parity.

    On the interest rate note, that is why calls trade at a premium to puts (on a low dividend paying stock). A trader can go long calls, short stock and collect interest in a hedged manner. In my article I tried to point out that retail traders do not collect interest on short sales.

    Which brokerage firm is paying you 4% on short interest? I’d love for my readers to know. I’m sure their commissions are also very low since this is a trader friendly policy.

    Thanks for the great comment.

  • On 10/30, Eyal Soha said:

    Sorry, I didn’t mean to imply that I’m getting 4%!  I just wanted to show how a loan at 0.25% is ridiculously cheap compared to something as solid as a T-bill, which is around 4%.  Usually you don’t get the “loan” for 0.25%, rather for 5+%.  Suddenly it’s not such a bargain!

    Eyal

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