New Trade LEN – Cheap Way to Fade the Homebuilder Head-Fake

by Enis July 23, 2012 11:50 am • Commentary

The homebuilders have made 5 year highs while the market has languished in the past 2 months.  A decent spring selling season has re-introduced optimism into a sector that was left for dead 3 years ago.  BUT, is all the good news priced in at this point.

Here’s what I wrote almost a month ago about LEN in particular and homebuilders in general.  I thought the momentum of the up move was strong enough that the stocks were not a short, but now that the up momentum has been stopped, and the stock is still in the same place, a new short position makes a lot of sense here.  Particularly because the options market offers a good risk/reward way to play for a move lower.

First, here is the chart of LEN over the last year, showing the decreasing momentum:



I’ve highlighted the decreasing RSI, shown by the arrow at the bottom of the chart, indicating lower momentum, even as the stock as stayed in the 30-32 range in the last month.  On a convincing break of $30, I think LEN could make a fast move to the 24-25 support area that I’ve highlighted with 2 horizontal lines.  That’s the area I’m targeting with my options trade.

Second, here is a chart of 5 year CDS vs. the stock price, a chart that I mentioned in the Chart of the Day post from June.



Once again, the stock is up 30% from its level in February, but the CDS level is in the same place.  The credit markets do not have the same confidence in LEN has stock investors are showing.  And the credit markets are usually right.

Broader markets are showing signs of increased stress, particularly in the European banking system.  The homebuilder stocks are oblivious to global growth concerns because investors think they are insulated, reflecting a stronger domestic backdrop.  Yet, we’ve seen this “decoupling” theory rebuffed numerous times before, and this time is no different.  So here’s the trade to play “recoupling” by LEN:


TRADE: LEN ($31.05) Bought the August 29 / 24 Put Spread for 0.60
  • Bought 1 August 29 Put for .72
  • Sold 1 August 24 Put at .12


Break-Even On August Expiration:

  • Profits btwn 28.40 and 24, make up to 4.40, with max gain of 4.40 at 24 or lower.
  • Losses of up to .60 btwn 28.40 and 29, with max loss of .60 at 29 or higher.


Trade Rationale:  

LEN options skew is actually quite expensive, so this put spread is a good way to take advantage of that high volatility on the 24 strike.  It helps us set up a trade with almost 7.5 to 1 risk/reward, risking 0.60 to make 4.40.