Option Strategy: The Homebuilder Dispersion Trade
Here, a look at an option strategy that can be used to minimize downside risk while gaining unlimited upside exposure.
Here is the set-up of the position:
The number of contracts I'm using is something I, and I think most readers, would be comfortable with. But of course you are free to decrease or increase the size as you see fit to match your comfort and risk.
First we are going to sell a call spread in the XHB.
- Sell 30 December $26 calls at $1.00 a contract
- Buy 30 December $28 calls at $0.35 a contract
Now let's go spend the $1,950 we collected by selling that call spread by purchasing some calls in the above mentioned individual names.
- Toll Brothers: Buy 5 January $38 calls for $1.75 a contract
- PulteGroup: Buy 10 January $18 calls for $0.90 a contract
- Beazer: Buy 20 January $4 calls for $0.30 a contract
As far as the upside, two important things to note:
- The long call positions have January expiration while the short call spread is a December expiration. This means that even after December expires those calls will still have some time premium, meaning we have theta working in our favor. [Editor's note: Time premium describes the part of an option price that is above the intrinsic value of the option. More time means there is a better chance for the underlying futures contract to move.]
- The XHB spread would need an 11% increase to be in-the-money and incur the maximum loss. But the strikes of the long calls are only 6.5% to 9% out-of-the-money. Based on our calculation for the expected outperformance of the individual names over the index, an 11% increase in the index would translate into a 15% gain from stock prices (if the position is long).This would push all those calls well into the money and deliver healthy profits.
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