Trading the Stumble in Home Building
News lately has been bearish for the housing market. The pace of price gains is slowing, and buyer affordability is becoming a problem for many consumers. Affordability is becoming an increasingly large problem in new construction.
Regulation and higher interest rates are raising the costs of builders and these costs are passed on to consumers. That shrinks the potential pool of new home buyers and further pressures the market for new homes.
With that background, it’s not hard to see how home builder stocks could hit a rough patch.
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The future outlook for the industry appears to be causing concern among traders who are selling some of the builders even when the earnings numbers are strong. That was the case recently with KB Home (NYSE: KBH) which came out with stronger than expected earnings.
The chart below shows that investor enthusiasm quickly turned to pessimism as the stock rallied and then sold off after earnings were reported.
Details on Earnings
The details of the earnings report were summarized by Zack’s which noted KBH delivered strong earnings of $0.87 per share, beating the Zacks Consensus Estimate of $0.78 per share. This compares to earnings of $0.51 per share a year ago. These are adjusted earnings which ignore non-recurring items.
This quarterly report represents an earnings surprise of 11.54%. A quarter ago, it was expected that this homebuilder would post earnings of $0.49 per share when it actually produced earnings of $0.57, delivering a surprise of 16.33%.
Over the last four quarters, the company has surpassed consensus EPS estimates four times, a solid bullish factor that should have been expected to boost the stock price. However, the stock has been selling off over the past year, even as good news mounted.
While earnings were strong, the rest of the financial statement did raise cause for concerns.
One of the reasons the stock sold off was the fact that revenue of $1.23 billion for the quarter missed the Zacks Consensus Estimate by 3.48%. This compares to year-ago revenues of $1.14 billion. The company has topped consensus revenue estimates two times over the last four quarters.
The trend in the estimate revisions trend for KB Home has been down. That is another factor that has been weighing on the share price. Zack’s concluded that, “the shares are expected to underperform the market in the near future.”
The stock chart gives no reason to fight the down trend. The weekly chart shows the steady decline in price. The daily chart shows the stock completed a down side break out of a narrow consolidation range. Both factors are considered bearish by technical analysts.
A Trading Strategy to Benefit from Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.
A Bear Call Spread in KBH
For KBH, we could sell an October 19 $25 call for about $0.43 and buy an October 19 $27 call for about $0.12. This trade generates a credit of $0.31, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $31. The credit received when the trade is opened, $31 this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $169. The risk can be found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($31).
This trade offers a potential return of about 18% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if KBH is below $25 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $169 for this trade in KBH.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.