Housing’s Recovery Offers a Short-Term Trading Opportunity
Trade summary: A bull call spread in PulteGroup, Inc. (NYSE: PHM) using the August $42 call option which can be bought for about $1.95 and the August $45 call could be sold for about $0.85. This trade would cost $1.10 to open, or $110 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $110. The maximum gain is $190 per contract. That is a potential gain of about 72% based on the amount risked in the trade.
Housing stocks have been moving higher on hopes of a strong recovery in the market. This can be seen in the chart of builders like PHM.
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The National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market.
The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next six months as well as the traffic of prospective buyers of new homes. This index is back to pre-shutdown highs.
Now, let’s look at the details of the news affecting PHM.
Barron’s reported that PulteGroup ‘s earnings “help demonstrate why builder confidence is rebounding to prepandemic levels.
The home builder reported earnings per share of $1.29. Adjusted earnings per share was $1.15, beating analyst consensus of 87 cents, according to FactSet.
The company reported 6,522 net new orders. While that is down about 4% from the same quarter in 2019, it is much better than what Wall Street saw coming. Analysts polled by FactSet expected new orders to drop to 4,999, which would have represented a 26.4% drop from a year earlier.
On a call with investors, Ryan R. Marshall, PulteGroup’s president, CEO, and director, said the recovery in new-home demand “was nothing short of outstanding.”
“Our second-quarter results show a remarkable rebound in demand, as April net new orders fell 53% from last year, only to see year-over-year orders increased 50% for the month of June,” Marshall said.
Demand picked up as the quarter continued, and much of it came from first-time buyers, he said, noting that June orders increased 77% in the first-time category. “The rebound in demand during the quarter resulted in our aggregate second-quarter orders declining only 4% from last year.”
The earnings beat comes amid other signs of activity in the new-home market. Applications for a mortgage to purchase a new home soared in June, according to the Mortgage Bankers Association, while new-home construction jumped 17% and builder confidence, a gauge of market conditions for new homes, rose to prepandemic levels after plunging in April.
Demand has continued into the first few weeks of July, Marshall said. “Obviously, the demand for new homes has experienced a dramatic rebound over the past 8 to 10 weeks, following the initial shock from Covid-19,” he said, citing several indications of demand for new homes.
Internet search data and website traffic point to an increase in interest in buying a new homes, Marshall said. “Despite the overlay of Covid-19, searches for new-home related terms has been growing since mid-March,” he said.
Marshall also cited shifting migration patterns that could be a positive for builders.
“Patterns point to a movement of renters and homeowners from urban centers into the surrounding suburbs. Based on an internal survey, roughly half of our division presidents report that their business has experienced a modest increase in demand from urban buyers, while several of our divisions referenced a material increase in such demand.”
A Specific Trade for PHM
For PHM, the August options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
An August $42 call option can be bought for about $1.95 and the August $45 call could be sold for about $0.85. This trade would cost $1.10 to open, or $110 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $110.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in PHM, the maximum gain is $190 ($45- $42= $3; 3- $1.10 = $1.90). This represents $190 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $110 to open this trade.
That is a potential gain of about 72% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying PHM 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 stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an 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 at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.