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Use Options to 'Time' Housing's Top

Use calendar spreads to outflank an elusive market top.

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

-- David Lereah, chief economist of the National Association of Realtors, speaking on


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.

In fact, time, in the form of decay, is the main wind behind this strategy's back. Initially, the long and short puts offset each other -- meaning you aren't likely to make or lose money in the short term. But the position becomes more bearish (delta, a measure of the rate of change in an option's value relative to changes in the price of the underlying, increases) as time progresses, because the time decay, or theta, of the options accelerates at a faster rate as expiration approaches.

Ultimately, the near-term puts will expire, ideally worthless, and achieve their purpose of reducing your cost. Even if share prices don't decline, or if they rise slowly or gradually, one can hopefully sell enough cycles of the front-month options to completely pay for the cost of the longer-dated put options, leaving the position in outright long puts free or at no future risk.

Putting a Calendar Spread to Work

Many of the homebuilders, including

Toll Brothers

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, all sold off sharply Friday and saw heavy option volume amid fears that the strong jobs number would lead to more interest rate increases. At this point, most homebuilders' shares are some 10% to 15% off their all-time highs, but I'll use the numbers on Toll Brothers to illustrate a calendar spread.

On Tuesday, with the stock at $50, it was possible to sell the September 45 put for $1.25 and simultaneously buy the January 2007 LEAP put for $6.50, or a net debit of $5.25 for the spread. The cost of the spread -- in this case, $525 per unit -- essentially represents the position's maximum loss. Some situations, such as a takeover in which all the time value of the long-dated options would likely evaporate, could result in the maximum loss in a short period of time.

Before explaining how to profit from this calendar spread, let's look briefly at another scenario in which lower prices could actually result in a loss. Let's say that the stock has fallen below $45 a share prior to the September expiration. Assuming you did nothing prior to the expiration date, you would most likely get assigned on your short put options, meaning that the buyers have exercised their option, requiring you, the put seller, to buy shares of Toll Brothers.

At this point you might choose to simply close the position by selling out assigned stock, and sell your long puts. Because the January 2007 puts, with more than 15 months remaining until expiration, would still be awarded significant time premium, the loss would likely be much less than the stated $5.25 risk. But you should be aware that there is a scenario in which you can be right in judging the stock's next move but still lose money.

Now, here are a couple of scenarios for making the calendar spread profitable, beginning with certain assumptions.

First, if the September $45 put expires worthless, meaning you are now outright long the January 2007 LEAP, one might the look to sell short the next front-month option. Another possibility is that on Sept. 19, the Monday after expiration, if Toll is still trading around $49, you could sell the October 2005 $45 put for around $1.25 per contract. (I used a basic option calculator to arrive at this price.) This will further reduce the cost and risk to $4 per spread.

Theoretically, assuming Toll shares and other variables remain constant, it would take about five option cycles, or expiration months, to pay for the January 2007 puts. Of course, it is likely the stock will change price, and this could either accelerate or lengthen the time period it takes to pay off the initial cost. So depending on how the stock trades, a myriad choices and possible adjustments are possible -- and too numerous to list.

But the concept of continually rolling forward and selling the near-term contract is a way to take advantage of the fact that the rate of time-premium decay accelerates as the option approaches expiration. This will continually raise the break-even point and, as mentioned above, can ultimately create a position that has no cost or risk but an unlimited profit potential with plenty of time on its side.

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 was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to