Why Now's the Time to Get Defensive

Do you hear that?

To steal a phrase from Simon and Garfunkel, it's the sound of silence in the market. And it's making me nervous.

Remember just 12 months ago, when the CBOE Volatility Index, the "VIX," was comfortably over 40, implying significant investor uncertainty? Those were indeed scary times, a few months after Lehman Brothers collapsed in September 2008, but as an investor I was actually more comfortable then than I am right now. There were a lot of great stocks on sale!

You haven't heard about the "VIX" for a while now because, guess what, it's back below 20 -- implying investor complacency. We haven't been this low since (gulp!) August 2008, before the Lehman Brothers debacle.

Scared yet?
Even though the stock market has charted a steady upward course since last March, I have a hard time believing that all is well enough in the global economy to justify complacency.

That's why now is the time to get defensive. That means:

  • Having cash available to invest.
  • Considering options strategies to protect your gains.
  • Building a watch list of stocks you'd want to buy at 10%-15% below current prices.

Traditional defensive maneuvers would typically include increasing your bond exposure, though with yields so low and interest rates inching higher, I don't think this is a great place to put new money right now.

My best friends call me "Cash"
Thanks to the government's policy of low interest rates and quantitative easing, there's been (by design) little reason to hold a lot of cash. That's helped fuel both the bond and stock markets, as investors looking for even a tiny profit needed to put their cash to work somewhere.

Still, cash isn't trash and there's simply no substitute for quickly seizing opportunities in the market. If you're 100% invested and the market loses value, you need to sell something (at a lower price, of course) before you can buy anything else. That's a tough position to be in when stock values become much more attractive.

In our Motley Fool Pro portfolio, for instance, we took advantage of last year's market downturn by using our cash to pick up solid companies like Intel (Nasdaq: INTC  ) and Autodesk (Nasdaq: ADSK  ) at very attractive prices. Today, we've strategically left a large cash balance in the portfolio to grab future bargains the market may throw our way.

Yes, you have options
Market volatility plays a major role in the pricing of options (calls and puts). This is because investors perceive "risk" as volatility and when volatility is low there's simply less demand from options buyers (who have the right to buy and sell a stock) who seek to improve returns with big moves in stock prices.

All of this is to say that when options prices are low and the market's been rallying, consider protective puts on stocks and exchange-traded funds that have made you big money.

Let's say you bought 100 shares of SPDR Gold Trust (GLD) ETF in November 2008 for $75 -- a $7,500 investment. The ETF currently trades for about $113 -- a nice 50% gain for you. By purchasing a March $110 put for $2.75, you can lock in a sales price of $110 for your 100 shares through March 19, 2010, for $275 per contract.

One scenario: The ETF doesn't fall below $110 by March 19 and you're out $275 (4% of your original investment). But hey, you can still enjoy any upside left in the ETF. The other scenario: The ETF falls well below $110, but you can still sell for $110 (minus the $2.75 per-share cost) thanks to the protective put you bought.

Think of buying protective puts on your big winners as insurance against the chance of losing those gains in a market downturn. Even though you may grumble when you pay the premium for the put, just as with your auto insurance, you'll be glad you did if something bad happens. At the very least, it can give you some peace of mind in an uncertain market.

Make a list, check it twice
U.S. stocks have made a huge recovery from their March 2009 lows, and while I don't think they're anywhere near bubble territory, good values have become harder to find. That doesn't mean you should stop researching, though.

Here are five S&P 500 stocks with returns on equity over 15%, price-to-free cash flow ratios below 20, and manageable debt levels -- in other words, strong companies worth buying if the market does take a downturn.

Company

Price-to-FCF

Return on Equity

Total Debt to Equity

Coach (NYSE: COH  )

15.9

38.7%

1.37%

Gilead Sciences (Nasdaq: GILD  )

16.0

49.4%

24.40%

Cisco Systems (Nasdaq: CSCO  )

18.0

15.2%

25.70%

Stryker (NYSE: SYK  )

18.3

17.7%

0.30%

Automatic Data Processing (NYSE: ADP  )

17.1

25.4%

0.70%

Data provided by Capital IQ, as of Jan. 12, 2010.

Great companies don't always make great investments -- they still need to be bought at the right price.

Cisco Systems, for instance, has doubled its net income over the past decade, but remains 50% off its January 2000 prices. That's because investors were paying too dearly for Cisco's prospects during the dot-com bubble and, even though Cisco is a much better company today than it was in 2000, its 10-year stock chart doesn't reflect this progress.

That's why it's so critical to buy great companies only at the right prices. Another market dip could give us that opportunity, so prepare yourself now with a good watch list.

Get started now
When the market grows complacent, you need to get defensive -- no matter where you think it's going. It's only a matter of time before something spooks the herd and volatility once again ensues. By having adequate cash on hand to buy solid stocks at good prices and using options strategies to protect your gains, you can set yourself up for better long-term investment success.

That's our aim at Motley Fool Pro, where we use stocks, ETFs, and options to help investors make money in all types of markets. If you'd like to learn more about Pro, simply enter your email address in the box below.

Pro analyst Todd Wenning challenges you to say "The sixth sick Sheik's sixth sheep sick" three times fast. He does not own shares of any company mentioned. Intel and Stryker are Motley Fool Inside Value recommendations. Coach is a Stock Advisor selection. Automatic Data Processing is an Income Investor pick. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Autodesk and Stryker and has a disclosure policy.


Read/Post Comments (19) | Recommend This Article (109)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 13, 2010, at 3:12 PM, Nolte808 wrote:

    Fool is sure going into overdrive on getting people to 'consider' options lately. A quick search shows that articles with options is in the double digits just in the past 2 days. Same with online brokers, pushing options on the retail investors seems to be a new cash cow.

  • Report this Comment On January 13, 2010, at 4:58 PM, jrj90620 wrote:

    I would forget options unless you like being a loser.Very few investors have the psychology necessary to do well over the long run "playing" options.You should take up card counting and try blackjack in Vegas,for better odds.Like the other poster said,it sure is great for brokers.I would worry if having much cash since that seems like the most speculative,likely to depreciate asset one could own today.What a combination.Holding lots of devaluing cash while playing options.I'm not enough of a gambler to make that play.Will continue to hold my "risky" gold stocks.

  • Report this Comment On January 13, 2010, at 5:11 PM, LakeDaisy wrote:

    Well, Let's see ... According to the CBOE annual options volume increased from 283M in '03 to 1.19B in '08. '08 daily volume on just Indexes and ETFs was 2.3M, an increase of 32% over '07. Pretty good market and getting bigger everyday.

  • Report this Comment On January 13, 2010, at 7:23 PM, simonkathrein wrote:

    I agree with your opinion about a correction Todd. I also believe that once we start a pullback, the odds of continuing the bearish trend set last year is very high. In fact I just posted an interesting video on this very topic a few minutes ago from a trader i follow. (review it if you want at http://stockcapitalist.com/don-harrold-makes-an-excellent-po...

    Also, I think options are an excellent way to use as a stock replacement strategy, or as a hedge against a falling market... IF USED CORRECTLY. When people lose a lot of money in options, it's usually for 2 reasons. 1) they over leverage themselves, and 2) they buy cheap out of the money ones thinking their getting a deal... because their cheap.

    Whether it's puts or calls... stick to deep in the money options with a delta of around 80, that have an expiry 4-6 months out, and only invest about 15% of what you normally would if you were buying the stock.

    If it's a call your buying because you feel the underlying stock will rise... and you would normally buy $10000 worth of stock... then buy a deep in the money call option for $1500 and keep the rest of the money in an interest bearing account and consider it part of the trade.

    Stock gaps down, your only at risk for the $1500... and unless it plummets a large amount you can even usually salvage half of the $1500.

    Stock goes up, your option increases exponentially and you end up making almost as much as if you owned the full $10k of stock.

    Put's work the same... except in reverse.

    If i thought the s&p was going to plummet tomorrow, i would probably buy deep in the money put options on SPY, that expires maybe in May or so... and I would only buy 15% of the amount I normally would spend to short the ETF.

    If this is confusing... we have some links to excellent educational tutorials that are all FREE at our blog. Just go to http://stockcapitalist.com/how-do-i-get-started-in-stocks-an... and check out post 4. An excellent tutorial on options by Chris Rowe.

    Trade Safe

  • Report this Comment On January 13, 2010, at 7:36 PM, petecat2 wrote:

    Options seems like a good idea if you a selling options. I think that I will stick with my energy fund

    and precious metal.

  • Report this Comment On January 13, 2010, at 7:43 PM, fbkscreek wrote:

    What percentage should one hold in cash at this time?

  • Report this Comment On January 14, 2010, at 1:40 AM, SlowThought wrote:

    I agree with petecat2. Selling options is a good business. That's why I sell covered calls rather than buying puts. You just have to be prepared to be forced to sell your position at a profit (which can be more painful than it sounds).

  • Report this Comment On January 14, 2010, at 8:06 AM, CarryOnAgain wrote:

    I agree with your description of the advantage of options, Simon. You could also add, that if the price of the underlying security moves against you, you loose less money than if you held the security directly. This is because as the price falls back to the strike price, some of the instrinsic value gets converted to extrinsic (ie, time value).

    SlowThought, yes, selling covered calls is a good way to earn money on stocks. I have recently done so on my Coach stock. If your stock does get called away, you can always buy back on a dip.

  • Report this Comment On January 14, 2010, at 10:13 AM, mikecart1 wrote:

    Options are for those that want an "option" over burning money with the traditional lighter.

    :D

  • Report this Comment On January 14, 2010, at 3:40 PM, spinindog wrote:

    It's funny to see people shout their ingorance to the world.

    Trashing options as "risky" is just ignorant. An option can be far safer or carry far more risk than outright buying a stock. It can be anywhere in between for that matter.

    My grandfather was a farmer. Thought investing was stupid and kept all his money in cash. But he had the common sense not to shout his lack of knowlege to the world.

  • Report this Comment On January 15, 2010, at 10:41 AM, sofpan wrote:

    "Having cash available to invest."

    Why having cash ( = worthless, devalueating fiat money), when you can have Gold ( = solid rock, precious metal, used as currency and value protector, since King Tout times)?

  • Report this Comment On January 15, 2010, at 12:02 PM, NGBSA wrote:

    What I find interesting is the sudden uptick in promotions for "premium services" from Fool. I bought into one, they want me invested. Now here's one saying, in effect, "get ready to bail." A little something for everyone...

  • Report this Comment On January 15, 2010, at 2:16 PM, rajah51 wrote:

    Whatever happened to using stops and limit orders? Theu don't cost anything and are there for 90 days on a GTC order.

    Also, try Toy Boat three times real fast. Not so much to remember.

  • Report this Comment On January 15, 2010, at 4:18 PM, dsk315 wrote:

    Most of us, regardless of wealth, are realizing that traditional approaches (MPT & asset allocation) are theoretical strategies full of assumptions. Meaning: past results do not predict future perfomance. It sounds so mundane, but what it is saying is vital. Using historical measures of performance means nothing. Correlations real or not don't have the same relationship year in and year out. Investors want a better control of risk, especially in bad times.

    Options might be right for those who are looking to define risk rather than assume they have it under control.

    The best offense is a good defense and vice versa. Options allow you to play both, at the same time. Fact: nobody knows what will happen in the market, and even if somebody guesses correct, they don't know when something specific will happen.

    The way to succeed in all parts of life (including investments) is to hedge. Normally we hedge with insurance (homeowners, vehicle, medical...) Why don't more people insure their life savings? You got me. All I know is options allow me to do it and it has been very lucrative. In fact, my option positions have generated the bulk of my returns over the last 12 years.

    learn more: definedriskstrategy.com

  • Report this Comment On January 16, 2010, at 1:52 PM, WishToRetire2 wrote:

    My financial advisor keeps dispensing the dogma "You can't time the market". If you try you will make stupid moves. Therefore just be fully invested and wait. I've seen a lot of articles on this site that say the same thing.

    How do I reconcile the desire to make smart moves (such as suggested by this articvle) with the above?

  • Report this Comment On January 16, 2010, at 2:35 PM, scottj8 wrote:

    Wishtoretire2's point is also my question. Value (a la Buffet) type investors are aware of the experts ability to time and pick (and of course, over 95% of these so called experts never beat the indexes over time), but follow the belief that one can not time the market consistently so better to remain invested in good stocks one feels are long term values than to give over to the brokers the commissions.

    How can you reconcile this philosophy with reducing your risk short term but increasing your costs with put options?

    If one wants to be defensive, why not do just as rajah51 asks, use stop/limit orders and take your loss when the price is hit? Ex., instead of giving up $275 on a $110 put option on the exemplar stock, so that you lose $275 plus commissions if you lose your stock on a drop, just put in a stop order at $111. If price drops, your position is sold and you have not lost the money buying the put.

    I am confused.

  • Report this Comment On January 17, 2010, at 1:49 AM, scenicvista wrote:

    Stop orders do not necessarily execute, or do not execute where you want them, when the market is gapping down. Options are a contract and so long as the market is functioning the contracts will be honored.

  • Report this Comment On January 19, 2010, at 1:00 PM, JaysRage wrote:

    Let me get this straight. You hammer Cramer for CORRECTLY telling people to get out of the market Then you guys go ahead and pull the same crap by telling people that they need to have a significant amount in cash right now.

    You can't have it both ways.

  • Report this Comment On January 20, 2010, at 3:32 AM, thisislabor wrote:

    On January 14, 2010, at 1:40 AM, SlowThought wrote:

    I agree with petecat2. Selling options is a good business. That's why I sell covered calls rather than buying puts. You just have to be prepared to be forced to sell your position at a profit (which can be more painful than it sounds).

    slow thought has no idea...

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