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A Defensive Strategy That Works

Standing still or getting out of the market aren't options, so consider this time-tested strategy.

A big theme in my writing -- at and on my blog -- has been taking defensive action amid unhealthy demand for equities. There are several ways to measure this. I prefer taking defensive action when the

S&P 500

goes below its 200-day moving average, then getting fully invested when it goes back above that point.

As Ken Fisher has said many times, the market can only do four things: go up a lot, go up a little, go down a little or go down a lot. My use of the 200-day moving average is to try to miss as much as possible of that last one.

The attached chart shows a way that might help mitigate the full brunt of a bear market. It compares the S&P 500 (with its 200-day moving average in blue) and the

CBOE BuyWrite Index



Taking Defensive Action

Click here for larger image.


The BXM strategy is to buy the S&P 500 and sell at the money front-month calls. The intended effect is less volatility with the hope that it would outperform the regular S&P 500 over long periods of time. Every back test I have ever seen bears this out, but BXM should be expected to lag in years the market is up a lot, like 2003.

One way for broad-based ETF investors to take defensive action, without completely getting out of the market -- more on that below -- would be to hold the

iShares S&P 500 Index Fund

(IVV) - Get iShares Core S&P 500 ETF Report

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when the S&P 500 is above its 200-day moving average and switch to the

PowerShares S&P 500 BuyWrite ETF

(PBP) - Get Invesco S&P 500 BuyWrite ETF Report

, which is benchmarked to BXM, when the S&P 500 is below that average.

The chart also shows that, in addition to being less volatile than the S&P 500, BXM has outperformed SPX by 12% since SPX went below its 200-day moving average for good in late December.

The bigger picture logic behind the concept is that the stock market has an average annual return of close to 10% over very long periods. That approximate 10% includes all of the bear markets, crashes and busts that have occurred. By going down less during the bear phase of a normal stock-market cycle, as BXM (and its ETF proxy PBP) has done, that average 10% has a chance to go up when looked at over an entire stock-market cycle.

Compound this concept over several full stock-market cycles and there is the chance to be significantly ahead of the S&P 500.

There is an assumption that the buy write index will continue to function as it has. That something could change seems unlikely, but the current financial crisis should have taught us that many things we have taken for granted previously should no longer be taken for granted.

One obvious question is why not get completely out of the market when the S&P 500 goes below its 200-day moving average? For some people, this may be appropriate but zero exposure to the stock market is a big bet. Markets can turn up quickly and not give much of a chance to get in. The simplified example of switching from IVV to PBP as outlined above means not having to be correct about whether a move higher is the big one or just a fake-out. If the market goes up 20%, being in PBP would produce a lagging result. Not being in at all would produce no return. Lagging is much better than missing a big move up.

At the time of publication, PBP was a client holding, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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