By: Steve Smith
After being one of the best performing sectors in 2017 homebuilders have been pretty shabby in 2018. As measured by the SPDR Homebuilder ETF (XHB), the group is down some 12% year to date.
And because that ETF includes some companies that are only tangentially housing related such as Home Depot (HD) and William Sonoma (WMS) which has done quite well that it actually masks some of the underlying destruction of the individual builders including Lennar (LEN) Pulte (PHM) and Beazer (BZH) which are off 20% to 25% year to date.
Some of the issues:
- Weak demand as millennials are reluctant or don’t have the wherewithal to buy, slower household formation people having children later in life, if at all, and fewer immigrants which accounts for a good portion of new home purchases.
- Tight supply as builders have been slow to replace inventory for the reasons above.
- Private equity and other real estate firms have been more attracted to building and operating rentals.
- An increase in costs, from raw materials like lumber, to a tight labor market.
But, a recent positive earnings report from Toll Brothers (TOL) suggests things are not all that bleak, at least for some of the better-positioned builders.
I think TOL is positioned to move higher and I’m looking to establish a bullish option trade based on these considerations.
- Fundamentals: TOL caters to the middle and higher end markets which haves proved to be the strongest. It also recognized the trend of people, especially post-college, of wanting to live in more urban or walkable settings. A few years ago, it starting aggressively building amenity condos in downtown locations and it still has new units coming on stream, especially in popular second-tier cities such as Chattanooga.
When it reported earnings on August 21, the company handily beat both top and bottom lines and raised guidance. It also said it expects margins to improve as lumber and other costs have eased.
- Technical Analysis: I’ll keep this simple; after sliding some 40% from the January high, the stock gapped up following the aforementioned earnings report. This now:
- Broke the downtrend
- Saw a pullback to support level
- Is forming a bullish wedge
This sets up a great risk-reward entry point.
I have a target of $41 per share.
- The options: They have good liquidity with good trading volume, tight bid/ask spreads and most strikes have solid open interest of 100 contracts or more. It also offers weekly expirations giving good flexibility to structuring a strategy.
Currently implied volatility is 24% which is the lowest 5% of the annual range, meaning options are cheap.
The Strategy: Bullish diagonal spread.
This involves buying a near-the money longer-dated call and selling a further out-of-the-money call with a shorter(nearer) expiration date.
This position will:
- Have a strong directional bullish bias.
- Benefit from any increase in implied volatility
- Minimal theta or time decay—at some point theta may even be positive.
- Flexibility to adjust by rolling either leg to either take money off the table or defend and collect additional premium.
Here are the specifics of the trade:
-Buy to open October (10/19) 35 Calls
-Sell to open September (9/21) 38 Calls
For a Net Debit of $2.00
The trading plan:
- If shares move above $38, make an adjustment to take money off the table, and expand the profit potential with the ultimate target being $41 per share.
- If shares close below 35.50 I will exit the position for what will likely be a 35% loss.