Market Report: Are You Protected? Finding Cheap Downside Protection

We have a major battle taking place right now at 50-day moving average.

Today’s Dow chart clearly illustrates this point.

As you can see, the blue chips got absolutely clobbered on Friday, dropping nearly 400 points. And then, at the open of trading on Monday, the sell-off tacked on another 100 points in the morning -- before bouncing off those levels to end the day in the green and actually close above this critical 50-day moving average.

Then on Tuesday, the Dow gained 100 points only to surrender all of these gains (and then some) in today’s session.

What caused today’s drop?

Well, it’s the cumulative effect of three things. First, the National Association of Realtors reported sales of existing homes and condos fell 8% in September. That’s their lowest level in eight years! But to be honest, we all knew that housing was in trouble; that’s no big news.

Second (and most shocking) were the eye-popping losses reported by Merrill Lynch (MER: NYSE). The country's largest investment bank reported a Q3 loss of $2.24 billion (-$2.82 a share), which blew away the expectation of a per share loss of 45 cents. This could potentially open up a much more urgent credit situation than many market watchers expected.

And third, Amazon.com Inc. (AMZN: Nasdaq) fell 14.6% after reporting very strong quarterly earnings, but the fall was attributed to worries about profit margins during the critical holiday shopping season.

Throw everything together (and let’s not forget crude oil futures pushing $90 a barrel),
and it’s easy to see why the Dow was down as much as 180 points on an intra-day basis.

This is why Adam and I continue to stress the importance of holding protective put options in your portfolio.

In fact, over the last two weeks, we’ve added two new put options to our WOW ledger: one on Kohl's (KSS: NYSE), which is a retailer that’ll most likely disappoint Wall Street this Christmas season; and a second put option on United Parcel Service (UPS: NYSE), which just warned about weakness in its sales volume over the last three months of the year.

Each of these positions offers our WOW readers much-needed downside protection in a choppy market. As a trading tactic, I urge you to add some downside protection like this as well.

Now, at the same time, let’s not lose sight of the fact that the Federal Reserve is scheduled to meet on October 31. With Fed funds futures giving a 92% chance a 25-basis-point cut next Wednesday, it’s also wise to own some upside exposure as well. After all, we all know how the markets have reacted to Ben Bernanke lately: In short, they’ve been soaring whenever he makes a move.

By holding a careful position of both calls and puts, you’re putting yourself in position to take profits no matter what the market’s direction happens to be that particular day (or in this case, that hour). In a market environment like this, there is simply no other logical way to trade.

Bryan