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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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MINYANVILLE ORIGINAL Housing stocks -- both homebuilders such as Toll Brothers (TOL), Lennar (LEN) and PulteGroup (PHM), along with construction-material companies such as Lumber Liquidators (LL) and MDC Holdings (MDC) -- have been the best performing stocks this year with many of the names up 70% or more year-to-date.

Widely followed housing indices and ETFs such as the SPDR S&P Homebuilders (XHB) and the PHLX Housing Sector (^HGX) are up 58% and 51%, respectively, in 2012.

And things seem to just keep looking up for the group: Last week Fed Chairman Bernanke unleashed his latest bazooka shot, promising to focus on mortgage backed securities (MBSs). He hopes this will underpin home prices and create a wealth affect as well as spur new construction activity, which would go toward addressing unemployment.

On Tuesday Goldman Sachs (GS) issued upgrades and buy recommendations on a handful of names including some of those mentioned above. Also on Tuesday, the National Association of Home Builders sentiment index jumped to a six-year high. On Wednesday we'll get some more insight with existing home sales data.

But before jumping onto this bandwagon (as it is potentially very late in the game), remember that interest rates have already been at historic lows for over two years. But strict lending standards mean that many potential buyers, especially first-time buyers, have difficulty getting loans.

It also should be noted that many banks simply don't have the staff, or they have such a large backlog of properties in foreclosure, that the mechanism for transferring the Fed's bond buying into open-market lending just isn't in place. And of course all those (impending) foreclosures represent a large shadow inventory estimated near 1.3 million units which is equal to over a year's worth of sales.

Let's take a look at an option strategy that we can use to minimize downside risk while gaining unlimited upside exposure. This goes well beyond just buying calls.

Dispersion

A dispersion strategy is comprised of selling option premium in an index or exchange traded fund and simultaneously buying options on individual names that are components of the index. The theory is that the index, because some components will outperform others, will have a lower volatility. The dampening effect of some winners offsetting losers means the index should have a lower beta, or move on a lower percentage basis both up and down, than most of the individual names.

Large, sophisticated hedge funds will apply this strategy on both the put and call sides. They have the financial and computational firepower to do it with broad products such as the SPDR S&P 500 (SPY), where they can sell options on the index and then buy the appropriate number of options contracts on each of the 500 components in the index. (I don't think we are ready for that.)

Home Version

Let's look at how we can apply this concept to the homebuilders. XHB is up 58% for the year to date. That is impressive but still falls short as many of its holdings -- such as such as Toll, PulteGroup, and Beazer Homes (BZH) -- have gained 75%, 79% and 61% for the year to date. I'm going to use these figures to make the assumption that the individual names will continue to gain about 20 percentage points, or perform 33% better, on any continued upside.

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.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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