Free falling markets can be scary, but options can help you stand firm and emotionless. Many people initially gravitate toward options for their profit-enhancing leverage. But, in our opinion, the real power of options' leverage is that you can get substantial upside with very mitigated downside. That's what we are witnessing in our hypothetical portfolio in which we've been building the SPY position.
As of this writing, the spread has taken a beating. But the portfolio doesn't really care. This portfolio's worst-case scenario by year's end would be about a 5% loss. The market is already down more than that in '08. As was stated in the last issue, realizing the worst-case 5% loss should be easy to avoid. A technical bounce would help, but is not absolutely necessary... yet. As it stands, we can roll our short contract all the way out to December 2008 to bring a big, juicy chunk of premium thereby reducing our total capital at risk. What's more, we could liquidate and put all cash into the money market; but that would be boring.
For now, we're doing nothing in anticipation of a technical bounce.
Because SPY's price has fallen off the chart below, you cannot see that SPY is currently 3 standard deviations below its 50-week moving average. Talk about over sold! In fact, this extreme over sold condition tells us the odds are in favor of a bounce, though nothing is ever guaranteed.
The portfolio value below reflects interest earned on $9,099 in cash and the losses in the spread.
Principal: $10,000 || Position Value: $573 || Portfolio Value: $9,704
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This is not a solicitation or recommendation to buy any securities, options or financial instruments of any type. Any information in this email is for educational purposes only.
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Position Building: Week 4 
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