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 depends 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 stocks from among the top 5 biggest stocks by market cap in each of the 10 major industry groups that Standard and Poor's breaks out. Below is a selection of those stocks. 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

Disney Consumer Discretionary 38.37 Jan. 2013 $30 10.60
Coca-Cola (NYSE: KO  ) Consumer Staples 65.12 Jan. 2013 $60 7.70
Schlumberger (NYSE: SLB  ) Energy 82.70 Jan. 2013 $70 22.58
Citigroup (NYSE: C  ) Financial 39.17 Jan. 2013 $30 12.00
Pfizer (NYSE: PFE  ) Health Care 20.46 Jan. 2013 $15 5.75
Caterpillar (NYSE: CAT  ) Industrial 95.44 Jan. 2013 $75 26.50
Dow Chemical (NYSE: DOW  ) Materials 34.96 Jan. 2013 $30 7.45
Microsoft Technology 24.04 Jan. 2013 $20 5.20
Sprint Nextel (NYSE: S  ) Telecom 5.26 Jan. 2013 $4 1.83
Dominion Resources Utilities 47.83 Jan. 2012 $45 4.02

Sources: Standard & Poor's, Yahoo! Finance. Prices as of June 13 market close.

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 more than 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 or click here to get the latest information.

This article was originally published December 10, 2010. It has been updated.

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.

The Motley Fool owns shares of Microsoft, Schlumberger, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Microsoft, Dominion Resources, Disney, and Pfizer, as well as creating a diagonal call position on Microsoft. The Motley Fool has a disclosure policy.


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