Volatility creating trading opportunities in CME home price contracts

It appears that the notion that changes in sentiment will lead to greater trading volume, and possibly wider price swings, also seems to apply to derivatives on forward home prices.

The first of the three graphs below show how forward prices on the HCI (10-city index) contract for Nov 2020, went from steadily positive to spot levels through Labor Day 2018, then plummeted to a discount to spot until late February 2019 (as weak home sales numbers -particularly in California -dominated real estate news), only to even more quickly reverse to about a 2/3rds retracement versus past premiums over spot. This question of "where are forward prices headed" has dominated discussions on proposed home price trades.

The differences in outlooks that occur as forecasts evolve, seem to have lead to a recent spike in trading (that has also coincided with my increased efforts to support trading via social media). Note (in the second graph) that the four largest monthly absolute price changes for the last 40 months, all occurred during these last seven months (since Labor Day when prices began to collapse).

Finally, the bottom scatter diagram supports the notion (albeit with low R^2) that higher trading volumes are correlated with bigger absolute price moves.

Net, (to answer the question I've heard numerous times over the last 7 years) what the CME Case Shiller futures need to generate more volume, appears to be more volatility. Greater volatility seems to give those with home price exposure a greater incentive to hedge. The resulting higher volatility (given that these markets are not deep) gives traders more willingness to focus on these contracts, as price moves needed to reverse positions are taking place in weeks, not months.

I'd note that through the last seven months of increased volatility, bid/ask spreads have generally tightened/remained the same. My sense is that increases in trading activity lead to tighter bid/ask spreads as more traders (including this market maker) feel more comfortable in proposing the next trade, knowing where recent trades have occurred. As such, those new to this market are arriving at an interesting time where there may be both a perceived need to trade more (hedging as uncertainty grows) while at the same time, bid/ask spreads remain tight (or tighten?) as traders see opportunities for quicker reversals.

Separately, I'd also encourage new users to look at options for hedging. While traders might enjoy higher volatility, option buyers only have their initial premium at risk. While higher volatility should have translated into higher option prices, I've tended to leave prices on shorter-term puts relatively stable (adjusting for level of markets) in an effort to jump-start re-trading.

Feel free to contact me if you have any questions on this blog, or any aspect of hedging home price indices (to include option strategies).

Thanks, John