Use Options to 'Time' Housing's Top

"It's very hard for me to say 'top.'"

-- David Lereah, chief economist of the National Association of Realtors, speaking on CNBC Tuesday, Aug. 9, 2005.

Indeed, the word "top" is not only hard to say but it has proved extremely costly for short-sellers trying to time a top in homebuilding stocks. But after more than three years of increasing prices and improving fundamentals, could the bears' arguments for an eventual downturn finally have time on their side?

In a recent column, Howard Simons does his usual excellent job, analyzing how rising interest rates should slow real estate stocks' outperformance at some point. Note, however, that failure to outperform is not the same as an actual decline in price -- and in no way am I about to make that kind of crazy prediction again for the seventh time in three years.

Sidestep the Top

But options, specifically a calendar spread strategy, can be used to create a bearish position that helps avoid having to pinpoint the precise timing of the elusive top. A calendar spread, sometimes known as a horizontal or time spread, is used when one anticipates a gradual price move over the intermediate term, say, eight to 16 months.

The benefits of this approach, vs. being outright long or short the stock, are limited risk coupled with potentially limitless profit, and the relative ease with which the position can be adjusted in response to price movement.

A bearish calendar spread involves selling put options with a given strike and expiration date while simultaneously buying put options with the same strike price but a different expiration date. In the bearish case, the expiration date on the purchased (long) puts will be further out than on the sold (short) puts. In other words, the life span of the puts bought is greater than that of the ones shorted.