Building a Better High-Multiple Portfolio

This column was originally published on July 22, 2004 at 7:59 a.m. EDT.

We awoke Wednesday morning with a renewed sense of optimism that the doom and gloom surrounding the technology sector may finally be coming to an end. But the afternoon's selloff highlighted the market's vulnerability, and casts doubt on whether the 6.5% slide suffered by Nasdaq Composite over the last three weeks is truly at an end.

Given the continued rich valuations, and the beatings such as the ones Yahoo! (YHOO Quote) and eBay (EBAY Quote) recently received for merely meeting expectations, it's understandable that investors would be reluctant to step back in and buy the high-multiple names.

Last month, Jim Cramer described his frustration that his fear of owning high-multiple stocks has prevented him from adding names such as eBay(EBAY Quote), Broadcom(BRCM Quote) and Qualcomm(QCOM Quote) to his portfolio, despite his belief that one needs to own these names to outperform the market. Jim went on to explain that if he wasn't restricted from trading options, he would be buying calls to gain upside exposure in these companies.

Do What Jim Can't

Fortunately, most readers are free to do what Jim can't -- i.e., add some high-beta holdings by purchasing call options. There are advantages to using calls to construct a portfolio of high-multiple names: The leverage of options (one contract represents 100 shares) allows for a more efficient and flexible deployment of capital, while reducing volatility and offering superior profit potential and return on investment.

The table below compares the capital requirement, assuming 50% margin, of buying 100 shares each of eBay, Broadcom, Qualcomm and Yahoo! vs. the cost of buying one January 2005 at-the-money call option. The prices are based on Tuesday's close.

As you can see, to control 100 shares of all four stocks through the purchase of call options would cost just $2,330, about one-fifth of the $10,807 required to buy the underlying shares. You could further reduce the cost by purchasing shorter-dated options. And note that the risk in the option portfolio is limited to the initial cost, while the potential losses in owning the shares could theoretically be as high as $21,614 should all the stocks fall to zero.

I also included a column showing each stock's beta, which represents the expected price change in the stock for a given move in the overall market. For example, if the S&P 500 index declines 1%, you could expect shares of Broadcom to decline by 1.91%. But even though this is a volatile group of stocks, the use of call options actually reduces or dampens the volatility of holdings compared with owning the shares.

To understand this, it's important to make a distinction between the implied volatility of the related options, which affects the option's price or value, and the option's delta, which measures the rate of change in the option's price for a one-unit change in the price of the underlying stock.

Comparative Capital Requirements		100 Shares of Stock	At-the-money Call
Company Name (Ticker)	Price on 7/20	Initial Requirement	January 2005 Call Strike/Cost	Beta
eBay (EBAY)	$80.00	$4,000	$80/ $820	1.08
Broadcom (BRCM)	37.25	1,862	37.50/ 500	1.92
Qualcomm (QCOM)	69.5	3,475	70/ 650	1.15
Yahoo! (YHOO)	29.4	1,470	30/ 360	1.71
Total Cost/Beta	n.a.	$10,807	$2,330	1.46
TSC Research Based on closing prices 7/20/2004