It has long been my sense that retail investors prefer buying options to futures, as they know their maximum upfront payment, and they are comfortable with puts as a form of price insurance.
Further, I believe that options and futures/forwards feed on each other (dare I say "synergy"?) in that trading in one may result in activity in the other. For example, one can (in theory) delta-hedge an options position in the reference contract.
While the CME closed trading in options in Jan. 2020, I'm open to restarting markets in both options and forwards using my HPHF platform to offer OTC agreements. However, one of the things missing (to date) is a robust discussion of how to approach/bracket views on volatility, necessary to value options. Let me propose the following exercise to stir that pot.
The graph below shows the payouts on straddle positions in the Feb '22 HCI contract. I've used "straddle" here to represent either a long position in both a put and call (at the same strike) or a short position in the same put and call.^1 For example, the long straddle position owns a put with a 245 strike and a call with a 245 strike, and is assumed to have paid the offered side of the 10.0/14.0 bid/ask spread. The short (or writer) is effectively short those two options as if they sold the straddle at a price of 10.0. (Logistically, recall that per HPHF agreements the "short" will actually be a combination of other options, but for discussion here, the position is similar to a funded short.) Finally, I've used 245 as the strike on each as the CME Feb '22 futures contracts are centered there (closing 243.4/248.0 today).
As with my other HPHF agreements, I've bounded the payouts on both the put and call (in these cases at 25 points) to demonstrate that there will be maximum payouts on either side (equal to the maximum 25 points less the premium) that will be collateralized. See the HPHF page for a more detailed explanation.
Also, recall that the options are European style (to be automatically exercised only at expiration) to mimic the CME futures.
Finally, while a "point" in the CME contracts equals $250, any value of $/point can be negotiated upfront.
Clearly the straddle seller/ writer has a better profit profile if the index values end between 235 and 255, while the straddle buyer benefits both if the index ends outside the 231-259 range, and also if they can capture market moves prior to expiration (in 15 months). That is, while I don't promise any liquidity in the options, and any bid/ask spreads that might exist are likely to be wide, the HCI futures have had actionable two-sided markets every day, and bid/ask spreads tend to narrow as expiration approaches, so rebalancing a hedged position versus options might be a plausible strategy.
The answer as to whether the long or short is the better value depends on one's views on the volatility of the futures, and how each position fits a user's overall strategies. I'd note that while index values have been steadily increasing, the HCIG21 contract has ranged from 205-242 in the last six months -albeit an atypical market.
I'm open to quoting this straddle 10/14 for values of a point up to $1000 (in $100 increments only, please) given today's CME futures prices. If you have a larger interest, please contact me, and I'll try to drum up interest on the other side).
I used the HCI contract as it should be the starting point for valuing other regional options. (See the options page for updates to suggested offers on puts and calls).
The Feb '22 contract is far enough in the future to offer some value as a hedge, will eventually reflect the 2021 year-end values, and is the benchmark contract for other efforts (e.g. intercity spread quotes).
(Next three paragraphs updated Nov 19) While one could back into assumed volatilities for an option pricing model that would yield a bid of 5.0 and an offer of 7.0 on the Calls (try 4.6% and 6.7%) on this strike and expiration, my sense is that pricing will involve more than plugging a volatility into a model. For example, the reference contract (here HCIG22) is thinly traded and has a meaningful bid/ask spread. My options prices might reflect "inside quotes" or positions that I need to hedge in the contracts, or orders that I'm working. Home price indices are highly auto-correlated, which tends to lead to fat tails in probability distributions -a feature that needs to be addressed in option pricing models. Home Price indices may be subject to jumps should there be a cataclysmic event (hence, one of my uses for floors). Users will need to post capital to collateralize either a long or short position, and each user may have a different cost of capital from a risk-free rate. Finally, I've incorporated floors and ceilings in my quotes, factors that may be highly impacted by skew. (Vol smile).
Each user may have a different outlook and hedging needs, and their own sense of basis risk between an index and the house(s) that they hope to hedge. That there may be few alternative macro index hedges might bias inquiries away from "fair value". At the heart of this exercise, I'm quoting levels that (today) reflect my thoughts on market volatility, hedging needs to my existing positions, and to prompt discussions on at-the-money volatility.
The only truisms that I'd tee up are that: 1) home price volatility will be a small fraction of that of the stock market, and 2) regional volatility will likely be higher.
Feel free to contact me if you have any questions about this blog, have trade ideas that you'd like to discuss, or have any questions related to the notion of using home price index derivatives to hedge home prices.
Thanks, John
^1 I would consider other strategies (e.g. strangles, or delta-hedged longs/shorts) . I would also be open to quoting regional contracts.