Big Printin’ – IYR: Realty Check

by riskreversal October 12, 2016 11:10 am • Big Printin'

Yield proxies have taken it on the chin of late, with Reits, Homebuilders, Utilities and Telcos (AT&T & VZ) all down about 10% since July, after expectations for late 2016 rate hikes increased.

An interesting options trade in the IYR (the iShares U.S. real estate etf) caught my eye just after the open. When the etf was trading $76.57, a trader paid $1.68 for 15,000 of the Dec 78 calls and sold 30,000 of the Dec 82 calls at 43 each, or 86 total.  In other words, the trader bought the Dec 78 / 82 1×2 call spread for a debit of 82 cents, or $1.23 million in premium.

I want to breakdown how this trade makes and loses money…

The trade breaks-even on Dec expiration at $78.82, with a max gain of $3.18 or $4.77 million if the stock is at the short strike at $82. Profits of the trade trail off from $82 to $85.18.

On the downside, the trader can lose up to 82 cents between $78 and $78.82, with max loss below.

Assuming this trade is not against an existing long equity position, what’s the worst case scenario? First is a massive gap above the short strike. Think of the trade this way. The trader is long 15,000 of the Dec 78/82 call spreads but then to reduce the premium outlay is naked short 15,000 Dec 82 calls. The trader is making a bet that the etf will be higher, but not be above $82 on Dec expiration and thus willing to take the risk of incurring losses vs the winning call spread above the short strike. But to put the probability of losses above the short call strike in some context, the options market is suggesting there is only a 16% chance that the 82 calls will be in the money. So the worst case scenario is that the etf is above $86 on Dec expiration and not only would the trader lose the 82 cents in premium paid for the bullish bet, but then would effectively be short 1.5 million shares and suffer losses above that. Again this is a strategy for professionals as it eats up lots of buying power and has unlimited risk on a portion of the short call position.

But this strategy against a long stock position (which this could be) can be a great way to add yield / leverage to an existing long or be uses as a leveraged buy-write if initiated with long stock. In that case it acts like a supercharged over-write where leverage is added up to the 82 strike and then the existing long is simply called away above. For existing holders that maybe in the hole a little bit on a buy higher, 1×2 ratio call spreads are a great way to get back to profits on the next move higher.

And another reason for the attractiveness of the ratio could be the pick up in realized volatility (how much the underlying has been moving, white below) and the subsequent rise in implied volatility (the price of options, blue below):

[caption id="attachment_67042" align="aligncenter" width="600"]From Bloomberg From Bloomberg[/caption]

If the IYR were to settle or retrace some of the recent losses, short dated options prices would most likely come in, aiding this trade structure, because the trade is net short vega (volaitlity) with the sale of twice as many 82 calls than the 78 long calls.

Lastly, $75.50 looks like an a fairly healthy technical support level year to date:

[caption id="attachment_67043" align="aligncenter" width="600"]From Bloomberg From Bloomberg[/caption]