Playing Momentum Names While Limiting Risk

At my core, I am a long-term value investor. I work an 8-6 job, have a family, go to school at night and honestly don’t have time to be an active trader. I enjoy doing fundamental analysis, buying undervalued dividend paying stocks and investing for the future. Obviously, this limits the universe of stocks I invest in to a handful of companies. There is nothing exciting about investing in McDonald's (MCD), Johnson & Johnson (JNJ), Coca-Cola (KO) or Procter & Gamble (PG). There is no need to check your brokerage account every day -- or even every week, for that matter. One can sleep at night confident that one's money is safe. I’ll admit it’s boring, but it’s a dependable march towards financial freedom.

As a (relatively) young investor, I have the luxury of taking risk. While the majority of my portfolio is dedicated to broad-range ETFs and long-term stable dividend growth stocks, there is always a little slice of capital allocated at chasing the momentum companies. You know the ones I’m talking about: Netflix (NFLX), NetApp (NTAP), Apple (AAPL), Chipotle (CMG), Baidu.com (BIDU), Amazon (AMZN) and the like. These are the "castle in the sky" companies, the ones that jump 10 to 20 points depending on the mood of the market, where investors buy high and hope to sell higher.

For most investors (or traders) these are short-term holdings. When the momentum stops these companies are taken to the wood shed. Take F5 Networks (FFIV) for example. It posted a fairly decent report and dropped 30 points the next day.

For the common investor, these stocks are usually too pricey to initiate a large position. 100 shares of AAPL will set you back roughly $33,000. 100 shares of CMG will cost you $22,000. This is just not feasible for the average American investor. Furthermore, the risks in these commons are so high that it does not justify allocating huge percentages of your portfolio to single stocks. Still, there is big money to be made in momentum names, and to completely ignore this region of the market would be grossly negligent.

I play these names by using call options. Simply stated, a call option is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right -- but not the obligation -- to buy an agreed quantity of a particular commodity or financial instrument the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument, should the buyer so decide. The buyer pays a fee for this right (per wikivest). A single call option allows you to control 100 shares of the underlying security for a specified amount of time. When buying outright calls, an investor must be confident that the stock will rise in a certain period of time. This is a very bullish bet that the equity will rise.

Take the stocks mentioned above, AAPL and CMG; to initiate a 100 share lot in each company, your outlay would be roughly $55,000. To initiate an at the money call option on the stocks, with a three-month time frame until expiration, you would be looking at roughly $3,520. Even though we are banking on these stocks moving considerably higher in the next three months, I consider the option play monumentally less risky than buying the common outright. Sure, you can bet wrong; AAPL could tank the day after you buy your options. But it allows you to diversify across high momentum names so if one, or even two, fall, you have the ability to make considerable gains. Not to mention that there are repair trades that can dig you out of option wholes fairly quickly.

For companies with less volatility factored into their option price, I like to take a longer term approach, buying in the money calls with long-term expiration dates. Companies like Bank of America (BAC), Ford (F), Citi (C), GM, etc. These are stocks that should rise considerably over the next year -- and more importantly, they do not pay dividends. So by owning a leap on these stocks, I am not losing out on anything and can control considerably more stock for a minimum capital outlay. For instance, I can control 1000 BAC shares for one year for $2,940. Again, these are fairly deep-in-the-money calls. For these companies, I can exercise the options if I want to turn the trade into a long-term holding.

So if I were building a $20,000 portfolio. I would invest $15,000 into long-term, high-yielding companies and ETFs, and use the remaining funds to purchase call options on momentum stocks.

Ticker	Shares	Cost	Market Value	Yield	Total Yield
DVY	100	50.01	5001	3.41
JNK	100	40.28	4028	9.02
MCD	50	73.75	3687.5	3.3
JNJ	50	62	3100	3.4	4.78%
AAPL April 16, 2011 - $330	1	19.8	1980
CMG April 16, 2011 - $220	1	10.5	1050
Google (GOOG) March 19, 2011 - $605	1	22.6	2260
				Total Cost	$21,106.5

Obviously this is a rough portfolio put together for argument's sake. Here we have a relatively conservative portfolio yielding 4.78% on roughly $15,000. Additionally, it offers the investor exposure to large positions in momentum stocks via call options. The companies chosen for the momentum names are obviously interchangeable, and the expiration dates can be adjusted to better suit your risk tolerance.

If you are not looking at the company as a long-term investment, there is no need to own the common shares, especially if the company does not offer a dividend. The option market allows the average investor to play high-priced, high-growth names with minimal capital outlays. Anchor your portfolio in conservative safe companies and play the growth with options. It’s a winning combination.

Disclosure: I am long AAPL, JNK, DVY, MCD, JNJ.