Tuesday, June 20, 2006

Betting on housing

In the spirit of putting your money where your mouth is, I thought I would share my (limited) experience using the stock market to “bet against” the housing market.

DISCLAIMER: I know almost nothing about trading options. What I’m about to describe is not an attempt to “pump” shorting particular stocks or an outline of some “get rich quick” scheme. I’m merely sharing my experience of buying and selling “put” option contracts in order to make some money off of the housing markets decline.

WARNING: Trading “put” options is very risky business. Although your loss is limited to the total of your investment, (unlike other options scenarios where your risk may be unlimited) if you make a bad “bet” you will generally lose all your money. So proceeded at YOUR OWN RISK!

So, here’s the scoop.

If you think a stock (or a whole sector for that matter) is going to go south, a simple way of making a few bucks off of its demise is to buy a “put” option contract. Don’t ask me all the intricacies of “put” options because I don’t know them but what I do know is the following:

  1. When buying an option, you are actually trading in a contract that enables you to execute some sort of agreement in the future. In the case of a “put” option contract, it’s an agreement allowing the buyer “…the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month.
  2. You generally DON’T need to execute the options contract in order to make money on an options investment. The contract itself trades like any normal asset as there seems to always be someone willing to buy your options contract at any point in its lifecycle. Also note, you don’t need to wait until the expiration date to trade out of the option contract either. You can sell your option contract at any time.
  3. When buying a “put” option, the “strike” price is the price that if the stock should fall below, within its expiration date, you make money. You get compensated for the difference between the current stock price and the strike price. So the key here is that if the stock goes up ABOVE the strike price, and remains there on the day of the option contracts expiration, you lose ALL your money. Conversely, if the stock price falls BELOW the strike price (a state termed in the money) you make the difference between the current price and the strike price for every share you control.
  4. The key here is leverage. A single option contract controls 100 shares of a particular stock and therein lays the real magic of options. For a fraction of the price of actually owning 100 shares of a particular stock, you can temporarily leverage the volatility of 100 shares, and if your predictions are accurate, gain the real monetary benefits of having owned them long or short.
  5. Options are advertise in large ranges, grouped by expiration date and sorted by strike price. So, for example, “Toll Brothers July 30s” stands for an options contract that expires on the third Friday in July (July 21) and has a strike price of $30 per share.

To buy options you need to have a brokerage account that allows “options trading”. If you don’t have options trading enabled on your account, you can generally get the feature added with nothing more than filling out an options trading account application. For my existing brokerage account, I merely filled out and submitted an options trading account form online, and in a couple of days, I was up and running.

Ok, so you’ve got the general idea, now review the following excerpts to see how I made a few bucks shorting homebuilders, etc:

NOTE: Options are VERY volatile and move dramatically day to day. I was extremely lucky to not only buy my contracts in a sector that has been recently taking a major beating but also in an environment in which every major stock index and average has been WAY down. So again, don’t get too excited, and proceed with caution.

  1. Up 526% in just 8 days!!

On 5/10/2006 I bought 1 May 60 “put” option contract (I think… it could have been a MAY55 either way it was either in or very close to in the money the day I bought it) against KB Home (KBH) for $0.95 cents per share or $95 for the entire contract. In a short time, KB, along with all the other home builders took massive beating as it became even more apparent that the sharp falloff in buyers and large scale cancellations was not an anomaly. KB dropped from roughly $60 per share on 5/10 to roughly $54 per share on 5/18.

On the Thursday before the expiration day, I decided not to get too greedy and trade out of the contract with a healthy profit.

Outcome: $95 investment became $393.28 of profit!

  1. Up 342% in just under 30 days!!

On 5/17 I bought 1 June 55 “put” option contract against KB Home (KBH) for $2.80 per share or $280 for the entire contract. Again, KB along with the other home builders (as well as the market as a whole) took more beatings as investors got spooked by all the Bernanke nonsense. KB dropped from roughly $54 per share to roughly $45.50 per share on 6/16.

On the Friday of expiration, I sold the contract for $9.60 per share.

Outcome: $280 investment became $668.27 of profit!

  1. Current Active Positions:

Keep in mind; I could sell these contracts tomorrow for the percentage gains you see listed and turn my PaperMoney into real hard cash!.

Contrywide Financial (CFC) July 40 UP 54.95% + $138.30

KB Homes (KBH) July 55 UP 173.77% + $1307.55

KB Homes (KBH) October 55 UP 108.93% + $568.30

New Century Financial (NEW) Nov 45 DOWN 10.52% - $71.70

Toll Brothers (TOL) Sep 30 UP 50.03% + $140.00

NET GAIN: $2082.45

So as you can see, there may be some real benefit to being bearish on housing! The key here is, of course, is feeling confident about a steady, long term collapse of the residential housing market and finding basic opportunities where that decline might show itself best.

Some thoughts:

  1. Homebuilders are an obvious choice and although they are all roughly 30% down year to date, I think they could even fall further… maybe something commensurate with their meteoric run up from 2000 on.
  2. Mortgage lenders, brokers etc. may be a good choice as many may get hurt by both a dramatic decline in mortgage originations as well as mounting defaults. Long term, home loan banking may be a real ugly sector if a real protracted meltdown of housing actually occurs. The Federal Reserve has already been prodding lenders to tighten up their sloppy lending practices which may be a precursor to a more active role they would surely play if things get really bad. I bought Country Wide Financial (CFC) based on its high percentage of “sub-prime” (risky loans to borrowers with bad credit) loan originations.
  3. REITs that are heavily invested in residential housing may also be a good play. It seems most REITs are well diversified with a percentage holding both commercial real estate and residential housing but I think you can find some (that offer options contracts) that are skewed toward residential.
  4. Possibly companies involved in the supply of building materials since a drop off in new home building may put lots of pressure on them.
  5. Anything having to do with the American consumer as they will be the ones most affected by an extended housing downturn. I believe we may be entering a period of reverse wealth effect whereby the loss of our perceived home values coupled with widespread struggle to maintain lofty mortgages may greatly effect many Americans. I’m no expert, but it seems fairly likely that there’s going to be a bit of “belt tightening” up ahead.

I hope I have encouraged some discussion on the topic of “shorting” housing and I would be really exited to hear from others that are having luck as well, so please, share your thoughts and experiences.