The Cheaper Way to Build the Best Portfolio

Assembling a top portfolio of stocks can take quite a bit of capital. But if you're short on cash, a strategy that gives you a lot of the upside potential of owning stocks at just a fraction of the cost of buying shares outright could be the answer you've been looking for.

Struggling just to get started
Many beginning investors get frustrated by the amount of money it takes to put together a diversified portfolio. Discount brokers have made it a lot more affordable to buy small numbers of shares without paying an arm and a leg in trade commissions. But even if you just want to own a single round lot of 100 shares of a dozen or so stocks, you can easily find yourself needing $100,000 or more to round out your portfolio.

Of course, many investors with limited resources use mutual funds to build a diversified portfolio. By pooling your assets with other investors facing similar budget constraints, mutual funds -- as well as their newer cousins, exchange-traded funds -- give you a low-cost alternative to individual stocks that you can take advantage of with even the most modest of sums.

The problem with mutual funds and ETFs, though, is that they don't offer the huge rewards that individual stocks do. Many funds own dozens or even hundreds of different stocks, so while they do a good job of tracking the overall stock market or select sectors within it, they don't let you drill down on a select set of companies that you think will be the best in their respective businesses.

Here's another option
If you want to reap the potential benefits of individual stock investing but don't have the funds to buy round lots of all the stocks you want in your portfolio, you have an alternative that many investors never even consider: long-term equity options, also known as LEAPs. With LEAPs, you can earn profits similar to owning the stock outright -- but they don't cost as much as the shares themselves.

Here's how it works: A LEAP gives you the option to buy shares at a specified price between now and when the LEAP expires. The value of the LEAP is dependent on three things: the current price of the underlying stock, the fixed price you have to pay for shares if you exercise the option, and the length of time remaining before the option expires.

If the stock rises, then the value of the LEAP will rise along with it. With some LEAPs, there's nearly a one-to-one correlation between the stock price's move and the corresponding change in the option's value. But because exercising the LEAP requires that you put up additional money, the LEAP's value will always be less than the current stock price -- sometimes much less.

For instance, say you wanted to buy the stock with the highest market capitalization in each of the 10 major industry groups that Standard and Poor's breaks out. Compare the cost of buying shares outright versus what you'd have to pay to buy LEAPs on all those stocks:

Stock

Sector

Recent Share Price

LEAP Call Option

Recent Option Cost

McDonald's Consumer Discretionary $77.61 Jan. 2013 $65 call $15.30
Procter & Gamble (NYSE: PG  ) Consumer Staples $62.87 Jan. 2013 $45 call $17.90
ExxonMobil (NYSE: XOM  ) Energy $72.00 Jan. 2013 $45 call $27.55
JPMorgan Chase Financial $40.81 Jan. 2013 $30 call $13.40
Johnson & Johnson (NYSE: JNJ  ) Health Care $62.06 Jan. 2013 $40 call $22.50
General Electric (NYSE: GE  ) Industrial $17.13 Jan. 2013 $10 call $7.25
DuPont (NYSE: DD  ) Materials $48.32 Jan. 2013 $30 call $18.70
Apple Technology $319.76 Jan. 2013 $200 call $138.50
Verizon (NYSE: VZ  ) Telecom $33.56 Jan. 2013 $30 call $4.75
Southern Company (NYSE: SO  ) Utilities $37.93 Jan. 2013 $20 call $18.09

Sources: Standard & Poor's and Yahoo! Finance.

Now buying options isn't exactly the same as buying shares outright. Whenever you buy an option, you'll pay a premium that typically includes some value for the length of time left before the option expires. But although that time value decays while you own the LEAP, you can buy LEAPs with lifespans of over two years, giving you plenty of time for the stock to appreciate before all the option's time value goes away.

Also, even if you pay a little extra for time value, you also get a bonus with LEAPs. If the stock price falls below the exercise price of the option, you don't have to exercise it. You'll lose your premium, but that loss can be far less than what you'd have lost had you bought shares outright.

Be smart with options
Managing risk with limited capital is just one of the ways you can use options to enhance your investing. Our Motley Fool Options service has used options to deliver market-beating returns since its launch. We're planning to reopen the service to new subscribers soon, but the doors won't remain open for long. To learn more about Motley Fool Options and how options strategies can help you make money, just enter your email address in the box below to get the latest information.

Fool contributor Dan Caplinger leaps for joy when options trades go well. He doesn't own shares of the companies mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Apple is a Motley Fool Stock Advisor selection. Johnson & Johnson, Procter & Gamble, and Southern Company are Motley Fool Income Investor selections. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Apple, ExxonMobil, JPMorgan Chase, and Johnson & Johnson. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 10, 2010, at 3:26 PM, DrRonPaul4Prez wrote:

    I think there's a better approach. For someone who is not in debt, who doesn't have a lot of money but who is in the habit of saving up money, I would say invest in your favorite stock, save up money, invest in another stock, save up money, invest in another stock, and in time you will have a diversified portfolio. Now for someone who has a small amount of money to invest but won't be able to set aside more money for a number of years, a good mutual fund may be appropriate. As far as options go, I doubt that those are right for most investors. Unless you're a gambler and unless you've done a ton of research and really understand them, buying stock outright is probably the better route, because it doesn't have the same time requirement attached. All my opinion...obviously.

  • Report this Comment On December 12, 2010, at 5:18 AM, dmkap wrote:

    Although I agree with the basic premise of the article, I think you left out a hugely important point - a big difference between owning the stock outright and buying LEAP (especially when you look at the list of stocks you chose as an example). That difference being dividends. If you only buy the LEAP, you're not going to get any of the dividends, and in some cases (as can be seen in many Foolish articles), the dividend portion of the profits sometimes makes up a large percentage of the overall profit. This has to be kept in mind when choosing between LEAPS and buying fewer shares of the stock outright.

  • Report this Comment On December 18, 2010, at 4:25 PM, crca99 wrote:

    This is first time I've thought TMF said something irresponsible and potentially harmful. Persons who don't have enough capital to buy long are probably novice investors too. Address this article to business school grads only and I'd be more comfortable. The rest of us need to use a safer approach.

    DrRonPaul4Prez and dmkap made more tactful related comments.

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