Homebuilders Options Strategy - A Smart Way to Wait for Recovery

For several years I have been buying and/or holding Homebuilders at prices of less than 1 X tangible book, under the theory that over the long term they can be sold for at least 1.5 X tangible book. The long-awaited housing recovery remains just that – long awaited: meanwhile, my homebuilders rally fitfully and then sink back into the slough of despond. In order to get paid for sitting and waiting, I have been selling options – specifically, covered strangles.

The “covered” refers to the fact that I own the underlying security. At times of high volatility, I sell out of the money calls and out of the money puts, figuring the stock can't go both directions at once and I am happy to get paid to buy low and sell high, which is what I want to do anyway. Here are two examples:

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In the case of Toll Brothers (TOL), I can get paid a fairly good premium for agreeing to sell above the 52 week high or buy below the 52 week low. In the case of Ryland (RYL) the situation is not quite as dramatic, but I am still getting paid good premiums to buy near the low and sell near the high. The prices are from Friday's close, for the options I used mid bid/ask.

One way to look at it would be as a “rent-to-own operation,” done in stocks. If RYL is worth what someone will pay for it – 19.07, and the owner can collect 5.90 as rental fees from December to July, then the return, annualized, is approximately 50%. An assset that can be made to yield 50% annually is arguably worth more than its asking price.

This strategy makes sense for an investor who owns the shares and is willing to buy more at the put strike, or to sell at the call strike. It works better when volatility is high: 30 day historical volatility for both Toll Brothers and Ryland is over 100. Because it involves owning the shares and potentially buying more at a time when market conditions will be adverse, the investor should do his homework and determine that the downside potential for the stocks selected meets his risk tolerance.

I think homebuilders have good long term potential and in the case of Toll Brothers and Ryland I like the tangible book value, cash on hand, and available lines of credit. They will be survivors and will have good opportunities to capitalize by buying the assets of their weaker rivals at fire sale prices.

This strategy performed well on homebuilders until the bottom fell out, at which point it performed poorly. Since then, it has worked well again, because the homebuilders have gone up and down but over any period of time they haven't made any real progress. My opinion today is that a real recovery in homebuilding is unlikely during 2009, so the opportunity to collect premiums while I continue to wait for the recovery is attractive.

Disclosure: I own shares of TOL and RYL and plan to sell puts and calls on both companies within the next few days.