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Trading the Homebuilders With Calendar Spreads

This options strategy can limit risk and allow you to adjust your position.

The homebuilding stocks have been among the best-performing issues over the past two years, but there is a growing acceptance of the notion that the housing boom can't last forever.

Last Thursday, Credit Suisse First Boston analyst Ivy Zelman downgraded the sector, saying that "future gains are built into current prices, making it hard to defend the bull case." The downgrade sent stocks such as


(LEN) - Get Lennar Corporation Class A Report


Toll Brothers

(TOL) - Get Toll Brothers, Inc. Report





Beazer Homes

(BZH) - Get Beazer Homes USA, Inc. Report

down 3% to 6% on the day.

The question isn't whether the industry will see slackening demand, but when and by how much. But for those of you who want to try your hand in this sector, I'll suggest one of my favorite options strategies -- the calendar spread. Sometimes known as a horizontal or time spread, it's employed when one anticipates a gradual price move in the intermediate term.

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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.

Reducing Cost

Bulls and bears alike can use the calendar spread, but I'm going to concentrate on a bearish example. 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 farther out than on the sold (short) puts. In other words, the life span of the puts you bought is greater than that of the ones you've shorted.

The rationale behind this is that while initially the two puts are offsetting, meaning you aren't likely to make or lose money in the short term, the position becomes more bearish (your delta increases) as time moves forward.

Ultimately, the near-term puts will expire, hopefully worthless, and achieve their purpose of reducing your cost. That would leave you outright long the longer-dated puts.

The Scenario

Let's run through an example. I'm going to focus on Lennar, because the stock at $51 is only 20% off its 52-week high, while others in the sector are down even more. In the last year, Toll Brothers is down 41%, Ryland is off 39%, Beazer Homes has dropped 37%, and

D.R. Horton

(DHI) - Get D.R. Horton, Inc. Report

has slid 41%. Being a believer in reversion to the mean, I would argue that Lennar might have the furthest to fall.

With the stock at $51, we can sell the December 45 put for $1.75, or $175 per contract (remember each option controls 100 shares of the underlying security). We simultaneously buy the May 2003 45 put for $5.10, for a net debit of $335 ($510-$175) per unit spread. That $335 also represents our risk. We can only lose what we spend. (The options prices were taken from Nov. 12 quotes.)

But how do we profit? Here are some scenarios, and we need to begin with certain assumptions. If the December 45 put expires worthless, meaning that come Dec. 21 shares of Lennar are trading above $45, you are now outright long the May 2003 45 put.

Let me briefly digress. What if the stock has fallen below $45? Assuming you did nothing prior to the expiration date, you would most likely get assigned on your December puts, meaning that the buyers have exercised their option requiring you, the put seller, to buy 100 Lennar shares per contract.

Under this scenario, you are now long Lennar's stock. You would sell the stock, and you should sell your long May puts and probably will incur a loss that's slightly less than the stated $335 risk. The loss likely would be less, because of the time premium that would still be awarded, given the five months remaining on the life of the contract. Of course, that might be negated by commissions, so you must keep track of all costs involved.

But assuming that situation doesn't play out, and we are now outright long the May 45 put with a cost basis of $3.35, our break-even point is $41.65 ($45 - $3.35). Now we can do one of two things: stay outright long the puts, or sell (spread into) next month's option and further reduce our cost, which would raise our break-even point.

Again let's make an assumption. If, on Dec. 24, Lennar is still trading at $51, you could sell the January 2003 45 put for $2.10 (using a standard

Black-Scholes model to arrive at this price). This will further reduce our cost and risk to $125 per contract ($335 - $210).

Increasing Profits

The reason for continually rolling forward and selling the near-term contract is to take advantage of the fact that the rate of time-premium decay accelerates as the option approaches expiration. But with the break-even point now raised to $43.75 ($45 - $1.25), I wouldn't short the February 45 puts should the January series go out worthless.

So, come the next expiration on Jan. 18, 2003, I will be outright long the May 2003 puts with a cost basis and risk of $125 per contract. I'm now positioned to make $100 per put for every $1 per share that Lennar falls below $43.75 prior to the May 18 expiration.

If Lennar tumbles to $40, a 20% decline from current levels, the put's intrinsic value will be $5, or $500 per contract. That represents a 49% gain from the initial $335 cost, or a 300% gain based on the reduced cost. And of course, the further the stock declines, the greater the profit.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Steve Smith.