Basics – Taking another run at options -looking for 1 put writer

While most of  my blogs have focused on the Case Shiller futures contracts, there are option contracts listed on the CME that can be traded.  However, I’m not aware of any volume since 2014.  Recently though, I’ve been receiving a number of inquiries from individuals looking to hedge their home against price decline.  Like their car, home, or life insurance, they are looking to pay an upfront fee to insure against the negative consequences of a bad event.  Whether or not they use the label, they seem to have a preference for option-like products.  In addition, new forms of customized home price protection option-like products (e.g. ValueInsured ) have arrived on the market.  Finally (and I think that this has been a major catalyst driving inquiries), homeowners are beginning to question how much longer the rally in home prices will play out.  In effect, they are beginning to question whether they should be hedging.

To recap, the CME allows electronic posting of options (both puts and calls) on any expiration, for 10-point intervals, on four regions (CHI, LAX, NYM and the CUS 10-city index).  Options on other regions can be traded “ex pit” with a minimum of 20 lots.  (Please contact me for information, as I had one inquiry get close.)

A key difference between options in other markets and CME housing options, is that these are options to enter a position in the specific futures expiration, and not an option on the index.  While this limits the use of options against the spot market moving, it does offer a hedge against changes in expectations of future prices.   Also, since the option is on a futures contract, that contract can be employed in all kinds of option hedging strategy (to include, most importantly, expressing a view on volatility.  See more below).

(However, as options on futures, this product clearly falls into the “D as in derivative” world.  As such, I’ve had feedback that insurance companies regulators may look askance at members taking on such exposures.  In addition, option hedging strategies (e.g. delta hedging, or plays on “vol” decay) might look like proprietary trading to a bank examiner.  As such, efforts to find put writers need to be focused elsewhere.)

Until recently, I’ve tended not to maintain ongoing quotes on options due to both the number of quote permutations (2 calls vs. puts * 12 strikes * 11 expirations * 4 contracts = 1,056) plus the non-linear hedge ratios (in options vs. futures).  However, after first mentioning my interest to focus on one contract – LAXX17 230 puts -I’ve since received a number of inquiries on other region/put/ expiration combinations.  I’ll blog those here (and would be happy to tout your trading axes).  (e.g. CUSX17 200 puts were quoted 4.0/5.8 on Friday)

It turns out that the last two years would have been a great time to write options. Volatility in the futures contracts (i.e. monthly price changes) has been very low.  I highlighted in Friday’s blog  that volatility has been < 10% of that of the S&P 500 index (and under 4% outright).

CUS_SP500

I further noted that while some analysts have attributed the stock market “noise” to international events (e.g. slower growth in China, impact of lower oil on Russia),  that home prices seems to be primarily a domestic exposure (except for SFR, NYC inner city areas) and that homeowners benefit from lower energy costs (think heating oil and commuting) and interest rates (watch for a surge in refi index).

Net, the offsetting impacts of the above positive effects and of negative wealth effect from stock market fall, might keep home price volatility low.

The challenge of getting option trading re-started doesn’t seem to be in finding hedgers (at least at trades of <30 contracts).  Hedgers are open to paying a fee, even it means opening a futures brokerage account.  (That said, there are not many brokers who will let their clients trade futures as they are concerned about low volume and price exposure the other way.  However with options, once a client has paid the put premium, I’d argue that they can’t lose any more money.  Brokers should be more comfortable allowing put buyers.)

In my mind, finding put writers has been the dilemma.  Here’s why you might consider doing so.

I think that it can be argued, that put buyers, as with the other retail insurance products cited above, may not be looking to trade at the expected value given empirical or expected volatility of an index.  They are looking instead, to reduce the tail risk in their lives. and, in possibly paying a price through “fair value”, increase their personal utility.  As such,  I might expect (as with other retail products) a large number of small hedgers (eager to reduce risk) and a much smaller number of put writers who feel comfortable with the risk/reward profile.  Since there’s likely to be an imbalance between the number of put writers and buyers, the put writers will be more likely “price givers”, and the put buyers “price takers”.  Since I’ve not found many put writers (but hedge funds come to mind) I would expect early entrants to be able to set prices with limited competition.

While all put writers will have to post margin, an institutional put writer may have a lower cost of capital allowing them to maintain margin at a lower cost than an individual looking for 8-10% returns.

Since the options are on the futures, such writers should (in theory) be able to hedge their exposures with the referenced futures.  As such, both they, and I, have a vested interest in seeing liquidity in the futures markets improve.  I’m open to accommodating put writing activity via trades in the futures markets.

Writers need to appreciate that while the insurance products listed above can be aggregated with benefits of low correlation, regional home price declines are likely to be much more correlated. (And of course multiple trades on the same index all reference the same event).  As such, required returns might need to higher, and/or level of exposure might need to be lower.  In effect, this may be an interesting exposure for someone looking to a slice of a new risk to an existing business.

Finally, there is a concern that home price risk might be subject to jumps (e.g. earthquake, terrorism).  I have some ideas (use of bear spreads) on how such risks might be managed.

Net, for anyone interested, I’d be happy to share thoughts on put writing.  I’ve been posting the ask side quotes so far, but have to include a return on capital for potentially holding the position for over a year.  Again, take a look at LAXX17 230 puts, and if interested, contact me at johnhdolan@homepricefutures.com