Investors have been attracted to “Worst to First” stories this year as the first-quarter rally has favored stocks that spent much (if not all) of 2011 lagging the market. The two sectors topping this list, so far, are the Financial and Housing groups.
To date, the SPDR S&P Homebuilders ETF (NYSE:XHB) has appreciated by 24% while the S&P 500 Index is 11% higher. The relative-strength performance of the XHB and the housing sector overall is being driven by the implication that improvements in employment and other economic data points have likely forged a long-term bottom for these stocks.
Last week, however, the housing-related data delivered a mixed message as new homes sales dropped by 1.6% while median sales prices jumped by a reported 6.2%. Earlier in the week, the National Association of Realtors reported that existing homes sales dropped in February, though sales were still 8.8% higher when compared with the same period in 2011.
The mixed housing data compelled some of the housing bulls to lock in profits as selling pressure knocked the XHB shares from their highest prices since 2008. Technicians checking the chart will quickly notice the strong trend in the XHB shares as the 50-day moving average has provided staunch support since the ETF’s October bottom.
Interestingly, the strong technical performance and fundamental improvements among the homebuilders has gone unnoticed by the analyst community. The companies comprising the homebuilding ETF are among the least-recommended stocks by the analyst community, judging from the percentage of “buy” ratings. The fact that the analyst community has yet to start upgrading these names suggests the best is yet to come for this group.
So while it appears the path of least resistance is higher for the homebuilders, what particular stocks are ripe for some option trades? The following three trade ideas are a few strategies to leverage the potential upside in this sector.
First, the straightforward trade for the XHB bulls are short-term long calls on the ETF itself. Trading at $21.50, the next level of technical resistance for the XHB is likely to kick in about 4.6% higher at $22.50. The straight-up-the-middle call play for April expiration options could be the in-the-money 21 calls, currently trading around 86 cents. According to the Black-Sholes model, these options would appreciate to $1.55 if the stock climbed to $22.50 within the next two weeks.
Next is a short-term paired trade for those that would like to “hedge” an XHB call. Let’s start with the same XHB April 21 call purchased for 86 cents for the bullish side. As explained above, this option could return around 80% if the XHB hits $22.50 over the next few weeks. To build the paired trade, we add a bearish position that we expect to lag the XHB performance over the next few weeks.
Among the lagging stocks in the XHB constituency, none have performed less impressively than Aaron’s Inc. (NYSE:AAN). The rental giant is the worst-performing stock in the XHB and its chart suggests that the road won’t be any easier moving forward.
I expect AAN has the potential to trade back to $25 if the market turns lower again. As of Monday’s close, the AAN April 25 put was trading for 44 cents. Again, according to Mr. Black and Mr. Sholes, this same option would double if the stock moved down to $25 over the next two weeks. This is a good candidate for the short-side of a paired trade with the XHB calls.
Finally, for the long-term bulls, let’s get semi-aggressive with a long-term option. Looking at the option montage, the January 2013 23-strike calls in the XHB are trading at around $1.53, about 20 cents less than the options pricing model suggests they should be trading at. I like the odds that the XHB will be trading in excess of $25 by January, a move that would easily double the value of this option ahead of its expiration.
As of this writing, Chris Johnson does not own any shares mentioned here.