The home-builders were one some of the best performers in 2017, with the SPDR Homebuilder ETF (XHB) gaining some 42% last year. However, they turned down sharply in January in the face of rising rates, concerns of changes to mortgage deductions and slower new home sales data.  They had a decent bounce along with the broader market before pulling back again. Today, we’re going to explore ways to profit from this trend with our options trading.

The industry concerns over new tax policy are overblown, as it only impacts a small percentage of potential new buyers. The recent interest rates increases will moderate, demographics are creating good demand, and we are entering the strong spring selling season.

One of the biggest issues facing the industry is a shortage of new inventory, as homebuilders have been slow to build and many people are opting to rent. Construction is starting to pick up, but the focus is still heavily tilted towards higher-end luxury homes and condos.

The lack of new homes, especially in the middle or step up market, has left current homeowners reluctant to sell. This in turn has created a very tight market for new buyers or those looking to switch back from renting to owning.

I think as the economy and wages continue to show gains, and household formation increases, especially among millennials, builders will begin to ramp up production to meet demand. At that point, their stocks will enjoy another renewed rally. For options trading, Toll Brothers (TOL)  is my top pick to capitalize on this resurgence.

Toll Brothers (TOL) a leading homebuilder reported earnings on Feb. 27, and posted beats on top and bottom line and provided generally positive guidance.  One key metric, new contracts signed , jumped over 29% to 1,800 units. This bodes well for an active spring.

Two potential negatives were rising labor and material costs, which could weigh on margins. The stock initially popped, but then reversed sharply with continued selling over the following days.

Some of the reasons I like Toll specifically among homebuilders include the following:

• It is focused on the higher end, which remains more robust and enjoys higher demand.
• It was early in adding urban properties such as condos and loft type multi-unit buildings to its mix to capture the trend of millennials living, and buying, in downtown areas. And not just in the tier one cities, either; we see revitalizing all over the map.
• Toll has kept its property and land inventories in control and at a good cost to maintain strong margins.

It is now at support near the $43-$44 level, which provides a good risk/reward entry point.

The Options Trading: I’m looking to employ a bullish diagonal call spread. Specifically,

Buy the April (4/20) 43 Call and Sell the TOL March (3/23) 46 Calls for a Net debit of $2.15.

The risk graph of the position looks like this:   

The plan is to manage the position over time through the processing of “rolling” the short leg out to collect additional premium.  If we can roll three more weekly expiration cycles, this should bring the cost basis down to near zero.

This would give us a “free” position with unlimited profit potential heading into the April 20 expiration.

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