While recent volume in CHIX13 helped to bring some attention to trading in the CME Case Shiller futures contracts, the real value-added will come when longer-dated contracts begin to be quoted with tighter bid-ask spreads. That will shift the discussion from measurement of recent home price trends, to the viability (if there’s depth) to hedging of current exposures and forward production (e.g. for home builders).
1) A look at the (all too familiar roller-coaster) graph to the right puts LAX index history, and recent CME mid-market levels, into perspective. The spot LAX index (where the black line ends and the green line begins) is up~35% from the low index values of 159.18 in July 2009 (and 159.53 in Feb 2012), and ~21.7% over the last 12 months.
The Nov ’17 LAX contract mid-market value of 253.8 is another ~20.5% above spot levels, and is within 20 points of the all-time high (As an aside, recall that the Nov ’18 contract will be launched in ~3 weeks, and should be quoted ~260). As such, the CME mid-market futures are pricing in gains over the next four years, equivalent to what’s happened in just the last year. Is this a well-deserved slowdown (as underwater borrowers begin to see the light of day) or a too-conservative projection that underestimates the strength of the LAX market?
On Friday, the tightest longer-dated LAX contracts were LAXX15 232.0/239.0, and LAXX16 241.0/249.0. These probably are the two best opportunities for traders to square off in the “where is LAX headed” debate.
2) While outright markets might represent the purest bet on the level of forward index values, calendar spreads are a potentially interesting tool for discussions about how much a longer-dated contract should trade over a shorter one.
The table below has a recent set of calendar spreads for all of the November expirations in the LAX contract. The table shows both the bids and offers, and the difference between mid-market to mid-market numbers. All numbers in the top portion are translated into annualized % changes in the lower section.
As with the graph above, the table shows the rate of year-on-year gains in the index to slow down from the last year’s 20+% increase, and dampening to a 3.5 to 5.0% range in the later years. Again, some bulls may view this as too much of a slowdown, while bears looking for home prices to stall, may see these implied HPAs as too strong.
Finally, a benefit to calendar spread trades relative to outright trades is that a trader can better fine-tune during what individual time period their views might differ from these quotes. That is, someone can remain bullish for the next year, but have a more negative view on prices between Nov 2014 and 2015. They can place a focused bid or offer on the X14_x15 calendar spread that might better represent their views than an outright, longer-term buy or sale.
3) Intercity spread quotes offer a 3rd way for traders to put a contract in a different perspective. The CUS-LAX X16 IC spread may be good way to frame the debate as whether LAX will outperform the CUS 10-city index (and by extension, how LAX will perform against the other ~78% of that index, as LAX= 21.8%). For those who believe that the California regions will move in tandem, LAX could be a proxy for ~38% of the CUS 10 city index (SDG=5.5%, SFR= 11.8%). As such, the CUS_LAX IC spread might be viewed by some as a call on the 38% California vs. the 62% non-California exposures. Since the three Northeast regions (BOS 7.4%, NYM 27.2%and WDC 7.8%) constitute 42% of the CUS index, some might argue that CUS_LAX is another way of debating LAX_NYM.
The table to the right shows that- unlike the last few years – LAX forward index levels (as evidenced by CME futures) are priced to perform about the same as the CUS index. The simplistic analysis above would convert the -40.0/-35.0 IC market into the bidder paying a level that would have CUS underperforming LAX by 1.4% between now and Nov 2016, while the seller is offering at a level where CUS would outperform LAX by 0.9%. Over the last two years the LAX index is up 24.3% while the CUS index only rose 14.2%. For the Nov 2016 IC spread to trade at ~even gains over the next three years, one of the two series (CUS, LAX) will have to change pace dramatically.
4) Finally, I list options here only as a keep-in-mind strategy. There have been no longer-dated option trades since electronic trading was re-introduced in the spring of 2012. However, LAX (as well as CHI, CUS and NYM) are electronically traded so a platform for trading options strategies exists. While outright markets involving unlimited tail risk would likely be quoted with very large bid/ask spreads, there may be some interest in a form of intercity straddles and/or strangles. Traders may have views on relative volatility or differences in the shape of the tail risk between, for example, NYM or CUS and LAX indices. Others, looking to lock in gains, or bet against large further run-ups might want to buy puts or sell calls. I’m happy to make notice of any posted quotes that are brought to my attention.
Net, there are four ways to frame the debate on where the Case Shiller LAX index might be in ~3 years. Trading outright markets seems more effective than paying real estate agents, finding tenants and securing mortgages. For example, the 241.0/249.0 LAXX16 market is about a 3% bid/ask spread with limited broker fees for a fungible, publicly priced, transparent, tradable position. Contrast that with an approach of finding houses, determining the true bid/ask spread, paying real estate agents to sell (or rent) your property, securing mortgages, all while tying up capital in a unique, non-tradable asset.
Calendar Spreads and Intercity markets are two other options for a trader to narrow in on pricing via a relative value approach.
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