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Option Strategy: The Homebuilder Dispersion Trade

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Here, a look at an option strategy that can be used to minimize downside risk while gaining unlimited upside exposure.

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I'm choosing these three names because the first two are not among the top five holdings and Beazer isn't in the ETF at all. By being selective, I believe Toll Brothers and Pulte provide exposure to the high-end and first-time buyers respectively. Beazer, thanks to its low dollar share price, provides the opportunity to take advantage of the leverage afforded by options. But you are free to choose your own names.

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
This is a $0.65 net credit for the spread. This means we collected $1,950 for the 30-contract spread. If shares of XHB are above $28, an 11% gain, on the December 22 expiration date this position would incur a loss of $1.35 or $3,850 for the 30-contract position. Because this was a spread, risk is defined. Above $28 represents the maximum loss.

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
The total cost for these three long call positions is $2,375. So the full dispersion trade cost a $425 net debit. So, if the housing stocks turned south over the next few months, everything would expire worthless; $425 represents the maximum loss.

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.
Because we are outright long the call options on the individual names as opposed to the limited risk of the short call spread, our potential upside is unlimited.

Twitter: @steve13smith

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No positions in stocks mentioned.

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