The free fall in stocks Tuesday was something we have not seen in a long time. Many of the talking heads are trying to blame it on Asia and or technical problems at the exchange. Frankly that is bunch of bull, to put it nicely. The market fell for one reason, the same reason that any market falls, they simply ran out of buyers. After the run in the Dow we have had for the last year, traders should not be as surprised by this correction as they seem to be. The “easy” money in stocks is now over and we are entering into a period of much higher volatility.
So far we are seeing a dead cat bounce in the Dow. This correction is just beginning and it is very likely to get worse before it gets better. The trade I am suggesting is one the offers significant downside protection for a minimum of risk. Since almost all investors are long the market, putting a trade on like this is prudent risk management for any portfolio. This trade is short term and is only designed to offer protection for the next few weeks but it will be these next few weeks that most of the damage will be done. This trade offers both solid risk management for your portfolio and a very attractive risk reward ratio on top of that. We have 680 Dow points that we can profit in.
click on the chart to enlarge
Buy one March 2007 Dow Jones 12,000 put and buy one March 2007 Dow Jones 11,200 put, while selling two March 2007 Dow Jones 11,600 puts for a combined cost of 6.0 points ($600) or less to open a position.
Max profit at expiration, assuming a 6.0 point fill, is 34.0 points ($3400) and occurs with the Dow Jones trading at 11,600. Break even points are 11,940 and 11,260.
Max risk, before commissions and fees, and assuming a 6.0 point fill, is $600. This occurs at expiration with the Dow Jones trading either above 12,000 or below 11,200.
Odom & Frey
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