Should We Be Listening to Lenny Dykstra?

UPDATE: Lenny Dykstra is Out at TheStreet.com

(note: This is the first of three many posts focused on Lenny Dykstra’s trading strategy. Subscribe to our RSS feed to be sure you get the rest!)

Baseball great turned options-trading maven Lenny Dykstra is not a stranger to bad press. He’s faced steroid allegations, been sued by his publishing partners, and most recently, he was portrayed as a dishonest, homophobic racist in GQ magazine.

But I’m not hear to talk about that. I’m here to answer one important question that the mainstream media hasn’t bothered addressing:

Should investors be listening to Lenny Dykstra?

In 2005, Lenny began writing for TheStreet.com (TSCM), a former employer of mine. He quickly stood out for his baseball fame and unique investment strategy based around buying deep-in-the-money call options. He’s risen to writing the “Nails on the Numbers” newsletter for TheStreet.com, and remains a popular columnist for the site.

I met Lenny once at TheStreet.com’s offices and he was one heck of a nice guy with a great sense of humor. Back in the mid-to-late 1980’s, EVERY young Met fan loved Lenny Dykstra – he gave his all 100% of the time, and I’ll never forgive the Mets for trading him to the Phillies. But let’s forget all that for now and dig in. We’ll start with the most obvious question:

What the heck is a deep-in-the-money call option?

A deep-in-the-money call option is a call option with a strike price that is well below the current market price. Think of it this way - the lower the strike price versus the current market price, the deeper the call. As an example, here’s Research In Motion’s (RIMM) May call options:

(click to enlarge)

Since RIMM closed on Friday at $59.29, all call options below that price (shaded in the example above) are considered to be in the money. And as you go to $50, $45, and so on, the deeper in the money the call options are.

Lenny’s strategy consists of entering an order for 10 contracts (he has explained that his system is scalable for those with less capital) of a particular deep-in-the-money call option at a price below the current market price. If the trade is executed, he enters a good till cancelled (GTC) sell order at $1.00 above the price of the trade. So if a trade executed at $10, he immediately enters a sell order at $11.

Here’s Lenny in his own words, explaining what he believes are the advantage of this system:

In-the-money calls work to our advantage because of the leverage they provide. They give us exposure to a stock with significantly less money at risk vs. a cash or margin purchase for that same stock. Unlike buying a stock with cash, your risk on a call position is limited to the cost to buy the option. And be warned: Buying on margin is a dangerous game that I strongly urge you to avoid.

This is where I start having issues with Lenny’s strategy.

Lenny’s claim that DITM calls “give us exposure to a stock with significantly less money at risk vs. a cash or margin purchase for that same stock” is true if you care about the number of shares you are buying. But he fails to point out that there is a major difference between buying a stock on margin and DITM call options.

DITM call options can easily go to zero if a stock drops 25-30%. If you purchased a stock on margin and it drops, there is still a good chance you’ll have something left over, even with a margin call. Of course, that’s assuming the stock in question wasn’t something like Bear Stearns, Citigroup (C), or General Motors (GM).

And by saying your “…your risk on a call position is limited to the cost to buy the option,” he seems to be implying that this isn’t a significant risk when in fact it represents 100% downside risk. It is possible to lose more than 100% by buying on margin, but you would most likely receive a margin call and be forced to sell before that happened.

Add it up, and it’s obvious that buying DITM call options is equal to or more risky than buying stock on margin, which Lenny writes off as “a dangerous game.”

Lenny also advocates averaging down on his picks, saying the following in a recent article for TheStreet.com:

Sometimes our prediction is a little off at the outset. Inevitably, some picks will fall further before coming back into their own. And when stocks fall, we turn that to our advantage by averaging down. When the price of a stock goes down, a DITM-option price drops as well. That's our opportunity to buy more contracts at lower prices. I do this in order to lower my average entry price.

Here's an example. We got the call options in my pick Cisco (CSCO) at an average price of $8.10 a share on Dec. 12, when the stock closed at $16.99. I recommended placing a good-till-canceled sell order $1 above our entry price -- in this case at $9.10.

In mid-January, the stock began to drop. When that happens, my system calls for subscribers to place re-buy orders at specified price levels. When shares of Cisco fell to $15, we bought 10 more call contracts at a lower price. This lowers the average cost of each contract and each GTC order. Because options trade in 10-cent increments, some rounding may be necessary as the price of GTC orders drops.

Essentially, Lenny aims to lock in $1,000 gains, but fails to implement similar limits on downside risk. Throwing good money after bad doesn’t make an awful lot of sense to me, especially when the upside potential is purposely limited.

Make no mistake about it, like all unhedged options trading strategies, buying DITM call options carries high risk. And a portfolio of DITM calls is nothing but a leveraged bet on the market, even if you only select the most conservative, well-managed companies. If the market goes down 30%, you’re broke. If it goes up 30%, you’re rich.

Can you handle that without vomiting?

If people fully understand and embrace the risks of DITM calls, then more power to them. I won’t get in their way, but I will present what I view as the dark side of Lenny’s strategy. Hopefully, I’ll help investors make an informed decision as to whether Lenny’s style is appropriate for them.

Read more about Lenny Dykstra:

Inside Lenny Dykstra’s 99 – 1 record.

Lenny Dykstra Gets Lucky With Intel

Lenny Dykstra Was in Bed With AIG