This article is part of our series on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.
One of the biggest obstacles that keeps investors out of the market is simply not having enough money to put together a diversified portfolio of individual stocks. But even if you're short on cash, you don't have to resort to mutual funds and ETFs to invest. With the help of a simple strategy, you can get the upside potential of owning stocks for a fraction of the cost of buying shares outright.
The chicken and the egg
Even beginning investors know that in order to get your money to grow, you need to invest. But it can be frustrating to discover how much money it can take to buy just a dozen or so stocks. Although discount brokers have made commission costs a lot more manageable, buying small numbers of shares often isn't cost effective. Yet even buying modest 100-share positions can run an initial investment into the low six-figures.
The typical solution for small investors is to use mutual funds and exchange-traded funds. These vehicles let you own a tiny percentage of a big pool of investments, giving you instant diversification. But the downside of funds is that you can't choose to focus your money on the most promising individual stocks. So unless you find a money manager whose strategy exactly mirrors what you would do, you won't be completely satisfied with mutual funds and ETFs.
Pick the better option
Fortunately, there's a way to get the big rewards that individual stocks offer without having to break into a bank vault to get seed capital. Long-term equity options, also known as LEAPS, can give you profits similar to owning the stock outright -- but at a lower price.
LEAPS give you the right to buy shares at a specified price between now and when they expire. The value of a LEAP depends on the current share price of the stock compared to the price the option specifies to buy shares, as well as how long you have left to exercise the option. When a stock rises, then the value of LEAPS that are tied to that stock typically rise as well, and with some LEAPS, the value rises nearly in lockstep with the stock.
Compared to buying the stock outright, though, LEAPS will always be cheaper. That's because they require you to put up additional money to exercise your option to buy the shares. In some cases, LEAPS are a lot less expensive than the stock.
As an example, to assemble a portfolio of the top stocks in several of the S&P's major industry groups, you could use the following LEAPS:
Recent Share Price
LEAP Call Option
Recent Option Price
Johnson & Johnson
||62.81||January 2014 $50||14.20|
||41.86||January 2014 $25||17.50|
||73.89||January 2014 $50||26.08|
||42.05||January 2013 $30||12.07|
||15.53||January 2013 $10||6.05|
||32.38||January 2013 $18||15.45|
Procter & Gamble
||63.61||January 2014 $50||13.98|
Source: Yahoo! Finance. As of Oct. 6. Option price based on midpoint of bid-ask spread at close.
As you can see, what you pay for LEAPS is far less than the cost of shares. Put another way, if you bought a single LEAPS contract for each of these companies, you'd pay a bit more than $10,500, versus more than $33,000 to buy 100-share lots of the stocks.
Of course, LEAPS aren't exactly like buying shares. The price of the option includes time value that slowly goes away as the option gets closer to expiring. But by buying LEAPS, you get exposure to options with as much as two years or more before expiration, which gives the stocks plenty of chance to move before the options expire.
In addition, LEAPS miss out on something shareholders get: dividends. With some stocks, including several of the ones listed above, that can be a substantial sacrifice. But as an offsetting benefit, if the stock falls below the price specified in the option, you don't have to buy the shares -- and thereby avoid what could be a bigger loss than what you paid for the option.
Take a LEAP
If you want to start investing in individual stocks but don't have as much cash as you'd like, don't feel like you have to settle for funds. By using LEAPS, you can get most of the benefits of stock ownership without having to be rich to begin with.
Stay tuned throughout our options investing series and get the strategies you need to earn more from your investments. Click back to the series intro for links to the entire series.