Last week, the CME cleared the first options trade in the “new 7 regions” since their February announcement (see Jan 16 blog). Recall while options trading in home price futures was re-introduced in 2012 for CUS, CHI, LAX and NYM, that now options can also be traded* in BOS, DEN, LAV, MIA, SDG, SFR and WDC.
This inaugural trade –that was originally teed up months ago as an OTC trade – was done by a Denver real estate investor –trying looking for protection against an unlikely, short-term collapse in Denver regional prices. In “options-speak” it involved 6 lots of a slightly out-the-money put on the DENK17 contract where he was looking to protect some personal, notional amount of exposure. As such, both the type of party (a real-estate hedger) and the degree of protection (low fee, for protection against a market move over the next 3-9 months) was consistent with the 3-4 other trades I’ve done here.
Furthermore, I’ve received multiple inquiries, over the past few years, who have looked to hedge the same risk profile, but in regions beyond CUS, CHI, LAX and NYM. In fact, while the new contracts may expand the list of “coverage”, I also get inquiries for interest in hedging more narrowly defined geography areas (e.g. Greenwich), other regions that have Case Shiller indices (e.g. Seattle), to international cities such as Vancouver, to Beijing.
Many thanks to the folks at Insignia (who clear through IronBeam) and the CME for their efforts in facilitating this trade.
That all said, I used an asterisk (*) on trade, as the prospects for future trading in the “new 7” on the CME remains clouded. (Posting quotes on the four original regions remains as easy as trading futures, so it appears that there may be something different about how options on these 7 regions are “wired” (for lack of a better technical term)). It was a challenge to get the CME and IronBeam systems to agree on whether the options contracts were available (listed to be traded). Insignia is the only broker that I’ve used for these seven regions so I don’t know if anyone else can enter option quotes on these seven regions. Insignia has been extremely helpful and I’d like to continue working with them, but if another broker can post quotes on these options, please let me know).
On the other hand, the message coming from the CME sounds as their platform has been tweaked to be made more efficient in the last ~5 years and that these contracts may have been set up differently. After all, why would the CME want to allow quotes on potentially >1,000 permutations of strikes, expirations for both puts and calls, particularly on contracts with such limited volume?!? Bringing matched orders to an exchange for clearing, much as Eurex does with property derivatives might make more sense, and may be the path that the CME has taken. I don’t know for sure, but I hope to meet with the CME in the next two weeks to learn more.
Until I figure out how (or if) options in the “new 7” can be traded, I’m going to pursue multiple paths (e.g. being open to an additional broker, travel to meet with CME) as well as to try and foster options trading in the “new 7” via OTC trades.
OTC trades have challenges that I’ve written about before (see Dec 7 blog, or last week’s blog on NYC condos). I think that capping potential payouts is one way to limit counterparty risk. However, capping payouts, means working with smaller possible ranges of results. That probably makes more sense for short-dated options. Also many buyers have expressed an interest in disaster insurance, as a) they appreciated basis risk, and b) they only want to pay relatively small fees. Finally, a cap on payments means that writers don’t have to post capital against highly remote one-year price moves. Lower capital might lead to a higher ROE for put writers, thus enticing new parties to write puts.
Another feature to remind potential OTC option traders is that, as CME options are European in style (i.e. exercisable only at maturity), the OTC puts that I’m looking to foster will be so also. There may be others looking for put on a moving spot index, and there clearly are mortgage products (e.g. Value Insured) that offer hedgers to exercise whenever they sell their house (if in the money). While I’m happy to connect parties looking for such American-style options, my focus will be on one-time execution options.
As such, I’m going to focus on 6-12 month puts struck at levels that have a payout that kicks in (so strikes) at either about flat versus the spot index to -5%, with payouts capped at -10%. (Note that one-year forward prices on all ten regional CME Case Shiller futures are 3-5% higher than spot levels. As such strikes of flat, with payments increasing to some bottom floor of -10% will probably offer protection against all buy extreme outlier one-year price moves.
For purposes of illustration, here’s some levels that I’d suggest to start discussion on levels one where I’d write (sell) put options. I’ve used 6-, 9- and one-year forwards as Feb ’18 expirations will settle on 2017 year-end index values (which are typically released with a two-month lag). That will also align the expiration of these options with that of OTC forwards that I’d like to trade, that will also reference 2017 year-end indices.
The table to the left shows my suggested offerings if CME contracts could be cleared. I’ve used strikes near spot levels (but below mid-market futures prices) and with a payout band of 15 points, however any strike and band is theoretically possible. (If such trades were cleared on the CME it would be structured where the buyer buys a put at the strike and simultaneously sells one at the floor).
I’d love to hear from readers as to whether there’s any interest in put buying (or writing), these levels, and whether they have interest in other regions. Please feel free to contact me (email@example.com) to get this conversation moving.