Now's the Time to Get Defensive -- Again

Here we go again.

In January 2010, the market had been riding an 18-month rally and volatility was incredibly low. It was all a bit unnerving. At the time, I wrote: "When the market grows complacent, you need to get defensive. ... It's only a matter of time before something spooks the herd and volatility once again ensues."

Over the next seven months, market volatility increased, and the rally stalled. Indeed, it wasn't until the Federal Reserve introduced its second round of quantitative easing later in the year that the market began to ascend.

Deja vu all over again
Today, I'm getting similar vibes from the market and think that it's once again time to get defensive. Market volatility, as measured by the VIX, is at about the same level as it was in January 2010 despite increasing domestic and global macroeconomic concerns. Amid concerns about the U.S.' credit rating, potential default in Greece, continuing unrest in the Middle East, and higher food prices, all it could take is a spark to send volatility higher.

Though the Fed could introduce a third round of quantitative easing, it's certainly not a sure thing, so here are three ways to get defensive right now:

1. Raise cash.
2. Buy traditionally defensive stocks.
3. Consider options strategies that can reduce volatility.

Adding to your fixed income investments is another defensive maneuver, but with interest rates still very low -- thanks, in part, to quantitative easing -- there isn't much quarter to be found there.

Harvest moon
Of all the available ways to hedge your bets, cash is one of the best. Not only does your principal not fluctuate, but it provides you with the liquidity to take advantage of a market that could go on sale.

As you survey your portfolio for potential sale candidates, consider pulling the "weeds" first. One example of a weed is a stock that you've owned for over a year that hasn't performed well and hasn't lived up to your original thesis. Even if the market rallies, it's less likely these stocks would outperform.

Hunker down
The latest market rally has largely been fueled by cyclically sensitive stocks on a bet by investors that the economic recovery would continue. Indeed, the two best-performing S&P 500 sectors over the past year have been energy (up 39%) and materials (29%).

If you'd prefer not to hold too much cash, consider trimming positions in high-beta stocks and increase your holdings in undervalued lower-beta, higher-yielding stocks.

Here are few examples of the latter type of stock for further research:

Source: Capital IQ, a division of Standard & Poor's.

Each of these stocks has a dividend yield at least 50% above the S&P 500 average of 1.8% that could provide some income in a flat market. In addition, they offer a history of being less volatile than the market and bear price-to-earnings ratios below the market average of 14.8 times. If you're looking for defensive stocks, this is a good list to start with.

Know your options
When you own at least 100 shares of a company, another defensive strategy you can employ is writing covered calls to generate additional income in your portfolio and provide a little downside protection.

In a covered call strategy, you're agreeing to sell your stock at a certain price by a certain time. In exchange, you receive a "premium" -- income -- that's yours to keep no matter what. And it's the recurring income that covered calls generate which can help you reduce portfolio volatility in shaky markets.

The downside of covered calls is that if the stock surges higher, you've agreed to sell the stock for less than the going market price. If you think, however, that the market is going to trade sideways-to-down over the next few months, it is a way to be defensive and augment your income.

Get started now
The market is looking more uncertain, and now's the time to consider ways to protect your returns. Surveying your portfolio for potential sale candidates and looking for defensive stocks may be straightforward enough, but covered calls and options strategies can be challenging concepts to learn and properly implement.

If you'd like to learn more about options, our Motley Fool Options service is opening its doors to new members. Simply drop your email in the box below to get the information you need to start investing with options.