“The traditional techniques for managing portfolio risk are asset allocation and diversification,” he says. “Those ideas aren’t ‘wrong’ but they’re not good enough for today’s markets …. stock options provide the safety net that most folks need.”

Consider the following guest post from Mark, on the collar technique:

Option collars represent a basic, easy to understand and implement strategy that guarantees the safety of your stock market portfolio. Guarantee is a strong word, but it’s the truth.

Here’s how it works: You own 100 shares of stock, or, for passive investors, an ETF that mimics the performance of a broad-based market index. It may be SPY (S&P 500), IWM (Russell 2000) etc. The only requirement is that the ETF has listed options.

Next, buy one put option, giving you the right to sell those 100 shares at a predetermined (strike) price. Then sell one call option, granting someone else the right to buy your 100 shares at a predetermined (strike) price.

Often you collect enough cash when selling the call to pay for the put. That gives you the collar at no cash cost. The put strike price sets the maximum loss and the call strike price sets the maximum profit.

Such safety does not come free, so what’s the cost? There are two costs. First, as with any insurance, choose the deductible and decide how much you are willing to lose if the market tumbles. A reasonable choice is 5%, but it’s up to the individual investor. The second cost is the necessity to limit upside gains. You profit on rallies because collars are slightly bullish, but gains are strictly limited. No more +30% annual gains for collar owners.

Options have limited lifetimes, so this trade must be repeated at a time interval that suits you: one month, one year, or longer.

This is a very brief discussion, but what you get is guaranteed protection coupled with limited gains. Is that for you?

For an example, see this post by Mark. He also has written several books on options, such as the Rookie’s Guide to Options, wherein can be found more discussion of collars.

Sounds like fun! But bear in mind such competitions aren’t to be played the same way one should invest an actual amount of money. For one thing, you shouldn’t seek to own stocks for their short-run performance. It’s the long run where returns are less exposed to random fluctuations and lucky outcomes.

Nevertheless, Professor Moshe Milevsky won a Globe and Mail stock picking contest three years in a row and wrote a paper on how to win contests like these. What you do, he said, is pick from the most volatile investments.

This advice is somewhat qualified for those wanting to win the grand prize because it is based on risk-adjusted returns. But for the other prizes (see below), that is the way to go (and you still have a shot at the grand prize).

As well, the Prof would recommend, as I understand it, a contrary stance. Most participants will likely be assuming current trends continue, so it will be easier to differentiate your portfolio by going against the grain. 

Diversification is also a handicap to winning contests like these: the more narrowly focused the portfolio, the greater the likelihood of an extreme performance reading (up or down).

Putting things together, could the winning portfolio feature a prominently weighted Claymore NGX Canadian Natural Gas Index ETF? It has the volatility and is falling while everthing else is rising. But the oversupply problem in gas is quite severe and the timing could be off …

Contest details:

No purchase is required. Submissions have to be entered by Monday August 17th, 2009 at 9:30am ET. The prizes are:

• a grand prize of $1,000 cash (or a $1,500 donation to a Canadian registered charity of the winner’s choice) will be awarded to the competitor with the “best total risk adjusted performance”
• a “Wii Fit Bundle” (value of $453.99 Canadian) will be awarded to the competitor with the best total return performance
• an iTunes gift certificate, Starbucks gift card, or Claymore promotional merchandise (approximate retail value of $20) for those with the best weekly return performance.

To help with ETF picks, participants can use Claymore’s Portfolio Index Allocator Tool.

The market rallied just over 5% that day, so the tech “dinosaur” beat the market close to seven times. Some of Nortel’s leap might have been due to a contract win with Verizon Business announced Nov. 13, but the dramatic uptick likely was mostly due to market conditions and should provide some idea of the potential for gains once markets rally off their bottoms. If we get just a modest 15% rebound across the board within the next few months, Nortel could be 30% to 100% higher.

The most oversold stocks tend to lead the climb off the bottom, according to technical analysts. Nortel certainly fits the description of heavily oversold. So maybe there could be, despite the thick-as-molasses pessimism, some dramatic upside for Nortel shares over the next few months?

Nortel may or may not go to zero eventually, as some prophesize. In the meantime, though, traders, with nerves of steel might be well rewarded. Once again a caveat: as you may recall from this post, I am a long-suffering holder of Nortel shares.