Traditional advice says that unless you have a relatively large amount of money, mutual funds and ETFs are the only way to get enough diversification to invest safely. But as with most conventional wisdom, there are ways to build a diversified portfolio without breaking the bank. All it takes is a simple options strategy using long-term call options to get all the upside of owning an individual stock much more cheaply than if you bought the shares outright.
Why so many people never start investing
Most people -- even those who have never invested before -- know that in order to make your money grow, you need to make smart investments. But putting together a small stock portfolio can cost a whole lot more cash than you have lying around the house. Even if you stick to buying just 100 shares each in your stocks, you can find that it's just not affordable: adding just 10 to 12 stocks can cost as much as $100,000 or more, depending on the share prices.
By contrast, ETFs and mutual funds do all the diversification work for you. For as little as a few hundred dollars, you can open a mutual fund account that will give you instant exposure to hundreds or even thousands of different companies. That gives you the diversified portfolio you need, but it comes at a huge price: You give up your chance at the big payoffs that individual stock investing can bring. Occasionally, you'll find a mutual fund or ETF that owns exactly the stocks you want, but most of the time, funds will leave you with unwanted investments that fall short of your ideal.
Go take a LEAP
So if you want the potential of individual stocks without going broke, what can you do? The options market offers a great way to get started: Long-term stock options, also known as LEAPS, cost less than shares of stock but give you similar profits if the stock rises.
As with regular options, LEAPS come in two flavors: puts and calls. With calls, you get the right to buy shares at the option's exercise price any time before the option expires. Although it isn't an exact match, the value of LEAPS tend to track the movements of the underlying stock, so when if the stock rises, call LEAPS will usually also go up in value. In fact, if you're careful about which LEAPS you buy, you can find ones that rise and fall almost in lockstep with the stock itself.
The advantage of LEAPS over the stock is that they're always cheaper -- sometimes quite a bit cheaper. To exercise the options, you'd have to put up additional money. But there's nothing stopping you from selling your LEAPS rather than exercising them.
Take an example: Say you want to own some of the leading stocks in several sectors of the market. Here's a way you can use LEAPS to get that exposure.
Jan. 2013 $85
Jan. 2013 $35
Jan. 2013 $20
Jan. 2013 $90
Jan. 2013 $32
Jan. 2013 $60
Jan. 2013 $65
Source: Yahoo! Finance. Prices as of Dec. 7 close.
The difference in prices tells you just how much less you have to pay with LEAPS. Consider this: If you'd bought 100 shares of each of the stocks above, you'd pay almost $45,000. That compares with just over $8,500 for the equivalent LEAPS position. Obviously, $8,500 isn't chump change, but you can see how LEAPS help cut your upfront money commitment.
There is another price you pay for LEAPS, though. When you buy LEAPS, you pay a modest amount extra for what's called the time value of the option, which you slowly lose as the expiration date approaches. But you can choose LEAPS that expire as much as two years or more into the future, giving you a long time before that time value disappears.
The bigger downside of LEAPS is that you don't get the dividends that regular shareholders get. In some cases, that's a big loss. But on the other hand, if the stock really falls dramatically, your maximum loss is a lot less with LEAPS than it is with the stock -- you can never lose more than what you paid for LEAPS.
An option to consider
So even if you don't have a lot of cash, don't wait to start investing. By using LEAPS, you can avoid having to use funds, instead getting most of the benefits of stock ownership at a cheaper entry point.
LEAPS are just one way to take advantage of options. This month, we're offering you a free look at the Fool's "Options University." It's only available for a limited time, though, so go ahead and enter your email address in the box below now to learn more about how options can fit into your portfolio.
At the time thisarticle was published Fool contributor Dan Caplinger remembers his modest beginnings as an investor. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold and Philip Morris International. Motley Fool newsletter services have recommended buying shares of McDonald's, Goldman Sachs, and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. 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 Fool's disclosure policy keeps all your options open.
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