Option Traders Betting on a Bottom in Homebuilders

by: Joe Kunkle

Homebuilding stocks have not participated in the most recent market rally to the extent of other industry groups, and are still 24% off the April highs, while the market is only 10% off the April highs.

Much of the recent weakness is justified due to the very weak housing starts, pending home sales, and housing price index economic data released the past 3 months. However, the sharp falloff was expected as the first time home-buyer tax credit expired, and now it is likely that the trough has been seen. Shorting homebuilders became a crowded trade fast, and usually when everyone is on one side of a trade, it is time for a sharp reversal.

As we enter August, a seasonally strong period for home buying with school starting in September, I expect that we will see better than expected data, and the homebuilders will rally. The CEO of DuPont (NYSE:DD) recently stated that hosuing starts are likely to double.

Option traders are betting that homebuilders have very limited downside from here via put sales. Large blocks of puts have been sold in 3 large residential construction stocks in the past two days. The selling of puts naked is a strategy in which the trader feels shares will remain above the strike price, and is willing to take a large equity long stake if shares below that strike. The strikes being targeted are very near to current trading prices in this case, a sign that the downside in these stocks is also very limited. (Note: On Options Expiration Large Institutional Traders Will Manipulate Stocks so that these Positions Often Expire Worthless, Allowing the Trader to Keep the Full Premium Collected from the Sale).

The trades were as follows:

  1. Ryland (NYSE:RYL) saw a trader sell 6,600 September $16 puts at $0.80 with shares trading at $16.85 on August 3rd.
  2. Lennar (NYSE:LEN) saw a trader sell 10,000 September $14 puts at $0.63 with shares at $14.72 on August 4th.
  3. DR Horton (NYSE:DHI) saw a trader sell 10,000 September $10 puts at $0.38 with shares at $10.49 on August 4th.
  4. Toll Brothers (NYSE:TOL) saw a trader buy 3,000 September $18 out of the money calls at $0.625 with shares at $17.30 on August 4th.
  5. Homebuilders (NYSEARCA:XHB) saw more than 20,000 January 2011 $17.50 calls bought at $0.67 on August 2nd with shares at $15.25. Also, traders that bought more than 40,000 August $15 calls on July 19th have started to take some profits but also rolled 40,000 of the calls into August $16 calls. On July 21st a trader bought 10,000 September $16 calls and sold 10,000 September $15 puts.

The September expiration has been the focus in the homebuilders because earnings are expected to come in late August from Toll Brothers.

The charts for many of these stocks look similar, as expected, so looking at the Homebuilder ETF (XHB), we see that support was found at November 2009 lows after channeling down. Shares are now channeling up and a move above the 200 day moving average at $16 is needed to take away the possibility that this move the past month is part of a large bear flag. The chart is below: (Click to enlarge)
Homebuilder (<a href='http://seekingalpha.com/symbol/XHB' title='SPDR Homebuilders ETF'>XHB</a>) Chart
The fundamentals are concerning when you look at margins, debt, and earnings, but looking at Price/Cash the average homebuilder is trading around 1.5X cash value. On a price/sales and price/book basis, most of the builders are trading around the levels from 2002 through 2004 on a sales basis, but well below the historical average on a price/book basis. Furthermore, the elevated short floats could cause a squeeze on any positive data releases, and although high, have been trending lower since early 2009 as shorts unwind trades.

A quick view of the valuation metrics the 6 most traded homebuilders are as follows:

Upcoming Catalysts:
1) August 17th: Housing Starts at 8:30am
2) August 24th: Existing Home Sales at 10am
3) August 25th: New Home Sales at 10am
4) August 31st: Case Shiller at 9am

There area lot of reasons why homebuilders could be a surprising outperformer for the rest of 2010, and being a contrarian with the housing stocks could pay off nicely.

Disclosure: Considering Call Options in TOL, KBH, and DHI