I had a recent inquiry that I’d like to share as there may be other traders in a better position to write short-term, low-premium puts.
A reader wanted protection against a decline in the Case Shiller LAX index below 95% of today’s spot index. Since there are options listed on the CME (for LAX, CHI, CUS and NYM) for every expiration, and every five point strike interval, I tried to steer him to the LAXQ16 220 puts (as spot = 232.87). Now I disclosed to the reader that there had not been any options traded since last year’s 35-lot (that I wrote for on a similar inquiry) and that I don’t think that they’ve even been quoted. However, much like I believe that the CME S&P Case Shiller platform is the best venue for expressing financial views on forward home price indices, the options contracts may be one of the best for hedging, or taking, one-sided exposure. Trades are on standardized terms and positions are fungible so trading in/out is conceptually viable (although there is no guarantee of someone showing up to take the other side if/when you’d like to unwind). Finally, the CME is counterparty to all trades so the performance risks of buying a put (or call) from a lower (or non-) rated entity is reduced.
Since these are options on CME futures (and not on the spot index), analysis should focus on the LAXQ16 market – which was quoted 246.6/253.0 at today’s close. (I’ve had other inquiries, and have reviewed other platforms, that operate on continuously exercisable options. Such options lend themselves to a different analysis, may be more prone to seasonal factors, and would be traded OTC (over-the-counter) which introduces counter-party exposure.) This discussion will focus on CME products but I’m happy to discuss other approaches.
Since the 220 strike is about 89% of the LAXQ16 bid, I viewed the probably of prices being lower than 220 as remote and was considering a price of about 3 points. However there were two issues that made that difficult for me (having lived through last year).
- One way that prices might drop below 220 would be “the big one”, an earthquake. Having seen what happened in the San Andreas movie, I didn’t want to take the risk of California falling into the ocean. (That event would also make counterparty risk extreme). A way to address such concerns (for both parties) is to trade option ladders -that is, for the hedger to buy 220 puts, while simultaneously also writing 200 puts. That caps the payout to 20 points or $250*20 or $5,000/contract. Other strike combinations can be arranged. Trading must be “orchestrated” for both sets of trades to done together.
- While adding a 200 floor, and capping the payout at 20 points, reduces counterparty risk, I would not be surprised if the CME (or your broker) requires tremendous margin, as the option contracts will likely be highly illiquid. Posting 20, or even just 10 points of margin for a year, given high expected rates of return on capital, might require a put writer to require a higher fee.
So, is there anyone out there that might be inclined to write 20-30 puts of these puts, but who has a cost of capital that might result in a competitive put premium? Feel free to send me a question (email@example.com) about this inquiry, or any other aspect of hedging home prices.