Home Prices Register Another Monthly Gain and Here’s How to Trade that High
The S&P CoreLogic Case-Shiller National Home Price Index rose slightly more than expected in July, with the national index rising 0.5%. The national index is now up 5.9% compared to a year ago. The national index is now at new all time highs, surpassing levels which were previously seen in 2006.
Other indexes track home prices in the 10 and 20 largest cities. These indexes confirm the trend seen in the broader index.
Source: Wells Fargo Economics Group
The chart above shows the national trends in prices. But, real estate agents around the country like to remind potential customers that real estate is a local investment. Digging deeper into the data we see that price gains have varied by market.
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Since the peak, just eight markets have fully recovered their losses. The remaining twelve remain under water with the average home in markets that experience bubbles, like Miami, Phoenix and Las Vegas, still well below their peaks. Seven markets remain at least 10% below their all time highs.
Source: Wells Fargo Economics Group
The Investment Challenge
Uneven gains make it difficult for investors to access the right markets to benefit from the rebound in housing. High costs and a heavy workload associated with maintenance also makes it difficult to invest directly into homes. But, there are alternatives available to investors.
Many real estate investment opportunities are packaged as partnerships. Even publicly traded real estate investment trusts which often trade just like stocks require extra forms for taxes which can be a burden when filing.
To bypass these challenges, investors can turn to homebuilders. These are the companies that build new homes. But, even here, there is the challenge of finding the right homebuilder which is working in the markets where growth is resulting in increased earnings and a higher stock price.
An exchange traded fund, or ETF, could be the simplest way to avoid the challenges associated with investing in homes. SPDR S&P Homebuilders ETF (NYSE: XHB) is an ETF that invests in companies associated with the industry.
Specifically, the “investment seeks to provide exposure to the homebuilders’ segment of the S&P Total Market Index (TMI), which comprises the following sub-industries: Building Products, Home Furnishings, Home Improvement Retail, Homefurnishing Retail, and Household Appliances.”
This investment is designed to allow investors to take strategic or tactical positions at a more targeted level than traditional sector based investing. The holdings are diverse but all should do well when housing is doing well.
The ETF’s top ten holdings are shown below.
Homebuilders like PulteGroup and D.R. Horton should obviously do well when construction is booming. The fund’s third largest holding, Tempur Sealy, is the well known mattress maker and it should also fare well when home construction is booming. New home owners often buy new furniture as they move in.
Home Depot is also on the list of XHB’s top holdings. This company is a supplier to many homebuilders. It is also a company that can steady performance of the ETF when the sector dips.
When customers are reluctant to buy new homes, they often update or remodel their existing homes. In this environment, Home Depot and even Tempur Sealy should do well. In this way, the SPDR S&P Homebuilders ETF is hedged slightly against a downturn in real estate. Although, the ETF should still be sold when the downturn becomes apparent.
A Specific Trading Strategy
To benefit from potential gains in homebuilding and a continuing rebound in real estate, an investor could buy shares of the SPDR S&P Homebuilders ETF. To gain significant exposure to the sector, this could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the ETF while limiting risk to the amount paid for the options. Although the risk is limited, it is still significant and is equal to 100% of the amount paid for the option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another call option. The call that is sold will have a higher strike price than the one that is bought.
Selling the call can help an investor pay for the costs associated with buying the first call. Potential risks and rewards of this strategy are both limited and illustrated in the diagram shown below.
Source: The Options Industry Council
This strategy is designed to profit from a gain in the underlying stock’s price but has the added benefit of avoiding the large up front capital outlay required to buy a significant position. Another benefit of the spread strategy is that it reduces the downside risks associated with outright stock ownership.
Any option strategy that works with a stock can also be applied in the same way to an ETF.
Both the potential profit and loss for the bull call spread are very limited and very well defined. The maximum loss of this trade is equal to the amount of the premium paid at the time the trade is opened.
The maximum profit of this trade is limited to the difference between the exercise prices of the options that are bought and sold, minus the amount of the debit that was paid to initially open the position.
For XHB, the October 13 options can be used. The October 12 $38.50 call option can be bought for about $0.80 and the October 13 $39.50 call could be sold for about $0.15.
The two transactions would result in a debit of about $0.65. Since each contract covers 100 shares, this trade would cost about $65 to open. This ignores the cost of commissions which should be quite small, just a few dollars, at a deep discount broker.
That is the maximum potential loss on the trade.
Remember that the potential gain is equal to the difference in the option exercise prices minus the premium paid to open the trade.
In this case, the maximum possible gain is $35.
To find the maximum gain, we find the difference between the two exercises. For this trade, that is $1 ($39.50 – $38.50). We then subtract the amount paid to open the trade from that amount. For this trade, that is $0.35 ($1 – $0.65). Since each contract covers 100 shares, the gain could be as much as $35.
The potential gain of $35 on the trade is equal to about 54% of the amount of capital risked, a favorable reward to risk ratio for many traders.
This trade will be open for just about two weeks. That is a short amount of time. If a trader could repeatedly make short term trades like this, they should be able to rapidly increase the amount of trading capital they have.
This is just one example of how options are a versatile trading tool that can meet many of your trading objectives. This is true whether your overall objectives are related to income or growth.
In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy could also simplify tax reporting for investors seeking exposure to sectors like real estate where tax reporting can be more complex.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.