Pair Trade Updates - Homebuilders and Brokers

By Dr. Duru written for One-Twenty

July 17, 2007

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The bulls will not be denied. As TraderMike would say, you can't argue with the price action. After last week's nifty and swift recovery from the latest sub-prime drama, I am a converted bear. And I can say that with confidence because I am but a speck in the financial universe and no one would bother considering me a contrary indicator (=insert smiles here=).

But the bear in me continues to lurk, so to satisfy both the caution and the craving, I am taking a greater and greater liking to pair trades where you make a bullish bet on a strong stock and a bearish bet on a related, but presumably weaker stock. The bullish bet allows you participate in a market rally, even if it makes no sense to the bearish side of the brain. The bearish bet allows you the comfort of protection in case the market gets crushed just as you suspected it would. These trades make the most sense when you think either of these scenarios has a high likelihood as the resolution of the latest market drama. So the best time to enter them is in the middle of a strong move up or down in the target stocks. My main targets are the two sectors at the epicenter of the sub-prime and general debt madness: homebuilders and brokers. These two sectors show the most promise for future increases in volatility and so far the trades have worked better than my initial expectations.

I introduced the concept for the brokers on July 4,and I laid the foundation for my pair trade analysis on the homebuilders on June 27. In both cases, I tried to find consistent criteria for pegging one stock relatively stronger than another. For the brokers I pitted Goldman Sachs (GS) as the stronger peer to Merrill Lynch (MER). Goldman is the top of its class. MER has been snared by its numerous dealings in sub-prime debt. I pulled the trigger twice with calls on GS and puts on MER. Both times I took profits in GS once I paid for the MER puts. I short-changed myself a bit on the GS profits, but my goal here was to test my analysis with small dips in the pool. MER reports earnings before the market opens today. I highly doubt the stock will take a dive since a lot of negativity has been baked into the stock, but certainly any big tumble would be a bonus for the pair trade. Both times I executed the trade, I bought the calls after GS had been hit particularly hard. GS has a great history of snapping back fast and that quick reaction has been the source of this trade's success. Finally, the idea is that if GS fails to snap back and the selling gets worse, it will take out brokers like MER at least as hard. Ironically, MER was the stock that snapped back from last week's sub-prime redux the best. It has since cleared well above the open on that day while GS is still sitting within the price range of that day. In the coming days and weeks, I will have to re-examine my thinking! For example, as the market puts behind it another scare and wall of worry, it might make more sense to buy calls on the broker that is hit the worst, regardless of all the other stats I posted earlier. After all, GS was the biggest loser, next to LM, during Feb/March's sub-prime scare.

The homebuilders have been rocked back and forth more violently than usual ever since I noted the bullish engulfing pattern which signaled a potential bottom in the homebuilder stocks. This pattern was quickly violated, and I had to post a bearish reset and put these stocks back on bear watch. Since then, there have been two additional big up days. On July 6, I could find no specific news as the XHB jumped almost 3%. In just two trading days, this big move was wiped out and then some as the sub-prime scare took center stage again. Then, as the market rallied, the homebuilders scrapped to find a bottom again. On Friday, the XHB popped almost 3% again as a part of this rally. This time, rumors of Warren Buffet's interest in buying the heavily shorted stock of Hovnanian (HOV) had the bears scrambling to cover shorts and the buyers betting on another bottom. I could not have asked for better action because in all this chaos, the better homebuilders rose to the occassion while the weakest ones failed to hold their rallies. The table below summarizes how the homebuilders fared since the June 27th failed bottom:

Stock Price Change: June 27 to July 16, 2007
CTX 5.3%
TOL 4.2%
MHO 3.0%
HOV 2.1%
MDC 2.0%
PHM 0.3%
SPF -1.9%
DHI -2.4%
XHB -2.6%
RYL -3.3%
WCI -3.7%
BHS -4.2%
LEN -6.4%
KBH -9%
MTH -9.1%
BZH -21.3%

You have probably already guessed what I am going to say: I picked up TOL for my calls and LEN for my puts. Monday was the clincher as TOL held steady as numerous homebuilders, like LEN, gave up much of the gains from the last pop...again. What helped this trade is that I initiated it on July 5th, when LEN finally had a decent up day after selling off for 4 days straight. LEN ended up a little lower than that and TOL has not really looked back since. A perfect one-two punch. Since I bought options with August expiration, it was tempting to hold on given LEN got a sell rating with a $30 price target last week by Pali Research. However, I never heard of the shop, and there is no need pressing the point when I am still learning how best to execute these plays.

In the coming weeks, I hope to continue to provide these kinds of updates (see disclaimer here). In the meantime, I am sure you can find some of your own. Just remember, the idea is not raw speculation, but a structured hedge that pays off when the market swings in one direction. This means, you need to give the play some time. If a nice swing occurs early, then all the better. Oh yeah, you might be wondering why not just do a straddle or strangle (calls and puts on the same stock, with or without the same expiration, respectively). There are two main reasons: 1) it complicates tax reporting (I can't go into the details here), and 2) you end up with options with directly dependent implied volatility and only one chance (one stock) for a big move.

Be careful out there!

© DR. DURU®, 2007