Using InterCity Spreads (IC) for relative HPA

In yesterday’s blog I touched on the notion that one might be able to use InterCity (IC) Spreads to express a view on the relative HPA performance of one region to another.  While some regional pairs might make sense to debate (e.g. BOS v NYM, or LAX v SDG) a good place to start, and to illustrate the concepts in greater detail, is in contrasting one region versus the CUS 10-city index.

The example I’ve chosen is HCI vs. LAX.  LAX is both the second largest Case Shiller region, but also (useful for this exercise) one where implied HPA is visibly lower than the 10-city index.

HCI_LAX IC analysis

The table to the left shows all the necessary parts for converting CME futures prices into implied HPA.  For example, the HCIG16 mid of 195.7 is 4.2% above the spot level, while the LAXG16 mid is only 2.7% above.  As such, one might infer that the CME prices are consistent with the LAX index lagging the 10-city index over the next year.  (I’ll let the economists and researchers offer reasons why this might/might not/ make sense.)

But what do you do if you disagree with the 1.5% premium of HCI vs. LAX (and you don’t want to take outright risk by just buying the LAXG16 contract)?  If you believe that it’s too wide, then selling the HCIG16 outright (at 195.0 or 3.8% above spot levels) while buying LAXG16 outright (at 234.8.0 or 3.6% above spot levels) results in trades consistent with only a 0.2% implied difference.  (A similar exercise results if you think the 1.5% is too wide and you try to go the other way.  You’ll get 2.7%)

This is where IC spreads may be helpful.  As with other spreads, IC orders are presented as the first contract (HCI) minus the second (LAX).  Someone with a more bullish view on LAX (vs. HCI) might look to sell the HCI/LAX G16 spread.  To do so at the outright levels described above would result in  “paying up” 39.8 points.   However in this example, the spread can be sold by hitting the -39.0 bid (Be careful with signs) or, as I’ve have already done, offer the spread at -36.0.

Net, the debate about the relative performance of the LAX index versus HCI has been narrowed to a 3.o point price range.  The red and blue lines on the graph to the right show the narrower ranges.   The blue line is consistent with the -39.0 bid, while the red line is consistent with the -36.0 offer.  In both cases HCI prices would result in out-performance vs. LAX, but now with the -39.0/-36.0 market the debate has been narrowed to a range of 0.6% to 2.1% (vs. the 0.2% to 2.7% range from trading the contracts at the outright levels).

Net, the candle graphs (from yesterday) may be useful for illustrating implied HPA across regions, and intercity spreads give traders a way to observe and to express relative value over narrower ranges.

Please feel free to get in touch if you have any questions with this approach, or if you have any ideas for IC trading in G16 or other expirations.