From the September 01, 2006 issue of Futures Magazine • Subscribe!

Hedging the farm, with options

Considering the incorporation of an options strategy along with, or in lieu of, a purely futures-based strategy greatly increases the diversity of choices available to an investor. This added flexibility can enable a trader to protect against exposure in ways not available with futures alone.

However, options often are viewed as being unduly complex and strictly the province of professionals or technically-oriented types. Many investors, especially some hedgers who may consider themselves less sophisticated, tend to shy away from options-based strategies. However, it is just such a hedger who may benefit the most from utilizing options, particularly in the housing futures market.

Consider one of the most natural hedgers in this market: the individual homeowner. With housing prices appearing to have topped out after having risen substantially through several years, this homeowner may be understandably concerned. The prospect of the bursting of a “housing bubble” is a legitimate concern, especially if like many Americans, he has taken equity out of the home recently. In the interest of preserving the value, the homeowner may simply choose to sell Chicago Mercantile Exchange housing futures in an amount equal to its current value, and roll them as they near expiration.

While this will grant protection from a general downturn in the market, there are a few problems with this strategy. For the typical homeowner, the hope is that it will appreciate in value through time, and the owner certainly expects to participate in that growth. Assuming a large portion of this growth is due to growth in the broader housing market, the futures our homeowner has sold in this case will precisely guarantee non-participation. A 10% gain in home value due to a rising real estate market will be offset by a 10% loss on the short futures. In the unpleasant scenario of an especially sharp rise in home values, our investor may need to borrow against equity gained in the home to cover the losses, especially if heavily leveraged in the mortgage, as many homeowners are. If the broader market outperforms the local market, or the house in question, the homeowner will end up a net loser on the trade. Imagine taking a big hit in equity because the market performed too well and you happened to be hedged.

The objectives of the investor have to be well defined. The typical homeowner is certainly concerned with a market downturn, but is interested in participating in a rally. Preservation of equity should be paramount, especially if the investor lives in an area that has seen outsized growth.

The obvious alternative to selling futures is to buy puts. The disadvantage is that every time the puts are rolled, premium is paid out in addition to the commissions and slippage on the trade. However, the benefits are substantial. The downside is covered, and the positive upside exposure is unaffected. Moreover, the question of shifting equity around to finance the losses on the hedge does not exist. Once the puts are paid for, they’re paid for.

And this is one place where the “naïve” hedger has a kind of advantage against the speculator or professional. The hedger need not be concerned with the deltas and gammas of option theory, or ideas about volatility and option pricing. He or she has simply to decide how much protection is needed, consider what it will cost and decide if the protection gained justifies the expense, just as in buying traditional insurance, which is essentially what is being done here. When and if the hedge is established, it need not be considered again until the options near expiration and need to be rolled.

With the futures you earn equity in your account immediately, while some options take a little longer to respond to market movement. While debate on whether the housing market is in a bubble that soon will pop rages on, statistics show the market will likely plateau if not turn down, so it may be a good time to try and protect current value. While studying the new housing contract don’t forget about options. Using options can provide a needed hedge without sacrificing your upside.

Pete Thomas is a senior broker and market analysts for RJO Futures, the retail division of R.J. O’Brien. Todd Puch is a market maker in options at the Chicago Mercantile Exchange.

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