How to Beat the Market Without Lifting a Finger

OK, you might have to lift a finger. But beating the market is worth it, isn't it?

To understand what I'll tell you below, you'll need to have some basic familiarity and comfort with options -- financial instruments that you give you the right to buy or sell an underlying investment at a future date. Click here and get a quick primer if you need it, then flip back to see my simple strategy.

Assuming you're not intimidated by these modest prerequisites, you'll want to read on.

Putting on a collar
No, I'm not suggesting a studded leather piece of punk rock apparel or a return to the days of tunic shirts and starched, glistening white neckbands. This "collar" refers to a combined stock-and-options strategy that has historically walloped the market while also protecting investors from losing their collective shirt during financial panics. 

Specifically, a collar strategy implemented with the PowerShares QQQ Trust (Nasdaq: QQQ), an ETF based on the Nasdaq 100 Index, returned 9.6% annually during the 11.5-year period ending in September 2010. This research was conducted by Edward Szado and Thomas Schneeweis, two sharp fellows from the University of Massachusetts. That highly respectable gain looks downright stellar when compared to the cumulative loss of 3% that befell the QQQ Trust itself. 

So what is this collar thing, you ask?  Simply, a collar involves simultaneously buying a put and writing a call against an underlying stock or ETF that the investor owns. In this case, the put limits potential downside in the price of the QQQ and the written call caps the upside. Hence, the value of the total investment is, well, collared. 

Now, the beauty of this approach is that it involves lower up-front costs than simply buying a put, as the proceeds from the written (sold) call help finance, or even fully cover, the cost of the put. Moreover, the inclusion of the put purchase provides far greater downside protection than does a call writing strategy alone. 

Even better looking, though, is the actual performance of Szado and Schneeweis' collar model. Just check out the table below.

Source: "Loosening Your Collar: Alternative Implementations of QQQ Collars," by Edward Szado and Thomas Schneeweis. Model assumes purchase of a 2% out-of-the-money six-month put and sale of a 2% out-of-the-money one-month call, at a one-to-one ratio against underlying QQQ shares. Option positions are settled at intrinsic value and rolled forward prior to expiration. 

A couple points stand out here. Not only did the collar strategy deliver excellent relative returns, but it also did so with about one-third of the risk (as measured by standard deviation) compared to a long stock-only position in the QQQ Trust. The strategy also posted positive monthly returns nearly two-thirds of the time, so it definitely fits the bill for those who desire equity-like returns and a solid night's sleep.  

The most appealing aspect of the QQQ collar, however, may well be how it performed during the bear markets in the tech bubble-and-burst period and the more recent financial crisis:

• From April 1999 to September 2002, the collar chalked up 21.6% annualized gains with a very tame 13.6% standard deviation. The QQQ trust, meanwhile, lost 23.3% annualized, with a hair-rending 42% standard deviation.
• During the financial crisis and subsequent recovery (October 2007 to September 2010), the QQQ trust lost an annualized 1% at a 26.6% standard deviation. The collar, however, kept investors saner and in the black, returning 3.8% annualized, with a standard deviation of only 10.2%.   

Is this strategy right for me? 
That's not for me to answer. But if you're interested in a hedged investment with respectable upside potential, then I certainly see it as an appealing partial portfolio allocation. Specifically, the QQQ has plenty of risk along with high potential rewards.

First up has to be Apple (Nasdaq: AAPL), which is the ETF's biggest component. The possible negatives here are manifold (and I say this as a shareholder): demand for the company's products eventually pauses or otherwise disappoints; something truly tragic befalls CEO Steve Jobs; or, more prosaically, with every investor and his great aunt already all-in, the stock simply suffers from a lack of new buyers.

Then there's Google (Nasdaq: GOOG), a company faced with potentially major regulatory headwinds while also wrestling through its own margin-pinching identity crisis. On that latter point, we can throw in Netflix (Nasdaq: NFLX), which just informed shareholders that the cost of continued growth is heading higher.

Moreover, not every stock in the QQQ has been a huge growth success story. Among its holdings, Cisco Systems (Nasdaq: CSCO) is down 35% over the past year as some fear that its days of dominance may be over, while Teva Pharmaceutical (Nasdaq: TEVA) has dropped 22% despite having some resistance to the general concerns in the industry over pipeline strength.

And there's still a big bad world out there! 
Yes, Fools, besides company-specific uncertainties, macro risk remains, even if investors are all but commissioning oil portraits of their portfolios' two-year charts. In fact, a recent survey of investment advisors reveals bullishness to be within a hair's breadth of October 2007 levels, right before all hell broke loose. In contrarian terms, that means that the emergency slide on the market is just begging to be pulled.

But whether the cause for the next selloff is developments at the global or company level, the QQQ collar should do a good job of seeing investors through relatively unscathed. Depending on such factors as volatility and the depth and pace of a downward move, the put component of the collar could even help deliver a net positive return.

Finally, aside from the QQQ, one can use a collar strategy on the SPDR Trust (NYSE: SPY), a proxy for the S&P 500 -- or any other ETF with options. But to create an accurate hedge for your portfolio, I recommend matching as closely as possible the volatility of the ETF to that of your stock holdings. In this case, the QQQ has historically been slightly more volatile than the SPDR Trust.

While you're mulling over whether to dress up your portfolio with a collar, keep an eye on the QQQ Trust and other tickers mentioned here by adding them to Your Watchlist today.

• Add QQQ Trust to My Watchlist.
• Add SPDR Trust to My Watchlist.
• Add Apple to My Watchlist.
• Add Google to My Watchlist. 
• Add Netflix to My Watchlist.