August 10, 2014

Using ETF Put Options to Bet on a Second Housing Crash

While housing prices are still more than 15% off of the highs set in the housing bubble according to the S&P/Case-Shiller 20-City Composite Home Price Index, we're up over 25% from the lows during the peak of the last bubble.

Meanwhile, many international markets are looking frothy, including Hong Kong and London. With international buyers now making up about 7% of the existing home sales market in the U.S., one might be justified in thinking we'll see the ripple effects if those markets face significant downturns.

Now I'm now much of a gambler, but occasionally I've been tempted to dabble in long-term ETF options. Shorting equities scares the hell out of me. Imagine shorting Tesla when it popped over $100 a share, then watching it march north of $250. For simpletons like me, the unlimited risk is too much.

Stock and real estate market fortune tellerIf you're bearish on U.S. housing over the next year or so, long put options are a relatively safer bet. Your maximum loss is the price of the option contracts. The iShares Residential Real Estate Capped (REZ) is dedicated to tracking residential real estate, but its trading volume is low and options volume is virtually non-existent. However, its performance tracks quite closely with the broader iShares U.S. Real Estate ETF (IYR),one of the most liquid REIT ETFs. IYR has a healthy options volume and is pretty diversified across all sectors of U.S. real estate (with heavy retail and office components, in addition to residential).

Since we don't know when (or if) real estate will crash again, LEAPS (Long Term Equity AnticiPation Security) are an interesting choice for two reasons. First, the odds of a crash at some point over the next year and a half or so is probably greater than hoping for a large dip in the next few months. Second, any gains on short-term options would be taxed at your short-term capital gains rate as ordinary income. Options expiring over a year from now get taxed at the long-term 15% federal rate.

That said, furthest expiration date for IYR is January, 2016, roughly 17 months from now. I prefer at-the-money options. Premium are higher, but your odds of success are better. As of the time of this post, IYR is $72.14 per share. The bid/ask for put options with a strike of $72 expiring in January 2016 is $6.90/$7.85. The $0.95 spread is a problem typical of options, even for some of the most liquid equities. On a round-trip trade, that's a huge hit and an immediate disadvantage. But let's assuming we can buy puts somewhere in the middle at around $7.40. That's over 10% the current price of IYR, so the stock would need to fall more than that for the trade to be profitable.

Is it worth it? Well, it depends.We have historical data going back to June of 2000 for this ETF - not bad. During that time, the average change over a 17-month period has been about a 4.1% increase. Put options insulate you from these increases (particularly large ones, like what occurred in 2010 during the rebound), but at a hefty price. You'd lose your entire 10%+ premium each time the ETF increases, occasionally break even on a moderate downturn, and could more than quadruple or quintuple your money during a severe downturn. Even factoring in the occasional 400% or 500%+ return on your option premium, your expected value of placing a bet like this is a mere 0.4%. You'll lose most of the time, make modest gains some of the time, and rarely hit it big (and that's if you expect we'll see another real estate crash of the same magnitude anytime soon).
Housing market crash - should have shorted housing stocks!
After commissions and trading spreads, one would be lucky breaking even over time buying puts on real estate. I've seen the same pattern in most other industries as well. Trading options always sounds like fun, but it's typically a lot more work than buy-and-hold strategies and it'll typically get you inferior results unless you really know what you're doing or you're extremely lucky (neither of which I am).

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