Pinch-hitting for Lenny

Lenny Dykstra was scrappy and successful as a major-league baseball player.  I often had Dykstra on my fantasy baseball teams, since I was always willing to “pay up” for him in the draft.  Since his retirement from baseball, he has been putting together an investment fund for athletes.  This is important since their big earnings years end early but their needs continue.  Dykstra has gotten some nice media exposure and also writes a column for theStreet.com’s premium site, RealMoney.

Reading his column today, I shouted out, “Hey, Ryan!  Lenny Dykstra recommends buying the July doubles (calls with a 55 strike, expiring in July) in Amgen.”

Ryan is our (very astute) trader and also a sports expert.  He asked, “Do you mean THE Lenny Dykstra?  Is this good news, or should we be selling?”  Ryan was joking, because we also hold a deep call in Amgen, one of our favorite positions.

Dykstra, according to this story, learned to identify key buying points by studying with Richard Suttmeier, chief market strategist for Joseph Stevens & Co., and also a RealMoney contributor.  Suttmeier uses technical analysis to determine key trading points and has a model that projects fair value for various stocks and sectors.  Dykstra uses this information for buys.  He chooses to sell quickly when the stock makes a small gain.  It is a very active trading style.

It is not our mission to tell Lenny Dykstra how to trade his positions, particularly since he says it has worked well for him.  For our readers, however, we would like to recommend an alternative approach.

What Seems Wrong

These options have a very high delta, making them stock equivalents.  Playing for a one-point move in the option, as Dykstra does, increases trading costs and caps the gain.  Dykstra does not offer any advice on what happens when the position moves against him.  This must happen with some frequency.  Is there a trading stop?  The strategy described runs counter to traditional trading advice about letting winners run and limiting losses.

What Works for Us

What we do is to use deep calls as a stock substitute in positions where we have a long-term fundamental view.  We use technical analysis to aid in entering the position and adjusting it.  We start with a call that has low premium over parity (15% or so) and about 85 deltas.  If the stock sells off, we have protection because the option gains more premium as it declines toward the strike.  The deltas become smaller and the premium over parity increases.  There is also an absolute limit to losses in case of some disaster.  If the stock declines and our fundamental reasons for owning it remain intact, we roll to a lower strike, perhaps in a longer month, and add dollars.

If the stock price increases, we roll the position up, taking money off the table.  This allows us to continue to profit from a big run while managing risk.

Summary

It all starts with identifying good stocks.  No system will work without a sound stock-selection basis.  We choose the same stocks in our fund that we buy in our successful program for individual investors.  We have proven that the deep-call approach has higher gains than a buy-and-hold strategy, while taking less risk.

A crucial concept is taking the right position size.  We do not buy more exposure in options than we would take if buying the underlying stock.  Those who use deep calls to take outsize positions are adding too much risk and getting too little diversification.

There are many ways to trade successfully.  Time horizon and attention to risk are both critical. Traders and fund managers who have some longer-term positions might wish to consider our approach.

Meanwhile, we wish Lenny Dykstra the best of luck in his efforts.  We hope that he can help many of our favorite athletes.