Building a Better High-Multiple Portfolio

Buying calls gives you a low-cost way to play richly valued names.
Publish date:

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





(EBAY) - Get Report

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) - Get Report





(QCOM) - Get Report

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


, which measures the rate of change in the option's price for a one-unit change in the price of the underlying stock.

Since at-the-money calls all have a delta of about 50, it's expected that every $1 change in the price of the stock will result in a 50-cent change in the option's value. In this way, the value of the options portfolio will fluctuate less and have a lower volatility than the underlying share price. Remember that an option's delta changes along with the price of the stock -- as the call moves further into the money, its delta, and the position's long exposure, also increases.

Typically, when determining the amount of options to buy, it's usually suggested to base your decision on share count rather than dollar amount. Just because you might have been willing to spend $2,500 to buy 100 shares of XYZ Corp. at $50 doesn't mean you should buy 25 of its call options at $1, or $100 a contract. The table below is an illustration of matching share count to reduce the initial capital outlay and overall risk.

But assume that you have $10,000 of risk capital and want to invest it equally among the four stocks ($2,500 each) mentioned above. The table below shows the number of underlying shares (again assuming a 50% margin requirement) and the number of call options that could be purchased for $2,500 at current prices. It also compares the profit and loss of each position based on the stock price moving 15% higher or lower over the next two months.

Note that allocating capital to options on an equal dollar-amount basis will result in potentially larger losses and profits due to the increased leverage of options. Also, it's important to keep in mind that if the stock prices remain unchanged, the options portfolio would incur a loss resulting from time decay. In this case, the value of our holdings on Sept. 20 will have declined by about $2,200, or 22% of the initial $10,000 investment.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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