A Thanksgiving Housing Options Treat

As I sit here in Palm Beach, Florida visiting my family for the holiday, much of the conversation (besides the pleasantries) has been about the devastating effect the real estate market has had, not only on the prices of the homes themselves, but the ancillary effects. These include rising crime, community dues increasing (due to increased number of vacancies/delinquencies), and insurance/mortgages companies failing or pulling out of the area (hurricanes probably don’t help either).

But with all that, my grandparents recently bought a new home and are quite happy to have paid 70% less than the previous owner who bought it 16 months before they did.

The point here is that value, in many ways, is subjective. Obviously there is going to be factual data that will influence the worth of something or one’s decision to buy or sell, but like homes, stock prices are determined by emotion and belief, much of it based on some sort of forward-looking thesis, (i.e.  back in the late-90s, everyone knew – or believed strongly – that the Internet was going to change the way we do business and be the next revolution in our social fabric.  The masses then bought, with almost no research whatsoever, any stock that ended in “.com”).

It could have been fuzzybunnyslippers.com that wasn’t making a dime and the stock may have gained 200-500% in a matter of weeks or months, with no fundamental data or earnings even to support such a valuation - just hope.

Part of what has happened in the real-estate market can be attributed partially to the “future value” fear that many Americans had.  Obviously this fear was not unfounded, but I am positive that it accelerated an already deteriorating situation.

Most of what a “market guru” does is realize when a situation may be a bit overdone (expensive or cheap), then takes advantage of that situation using calculated risk.  I have always realized my greatest returns when the market was in a buy frenzy or a sell frenzy and I took a contrary position.

Using this technique does require a bit of skill and also an understanding and examination of the behavior of the masses and how they have tended to act in the past.  I am not saying that the past tells us exactly what will happen, but it offers us a glimpse into the behavioral characteristics of market participants, allowing one to make an educated judgment or bet on the next move within a specific time frame.

As a long-time bull, I tend to take long positions. This would also be the norm for the majority of market participants. Currently, I believe the American economy is on the mend, and if you ask me where the S&P 500 Index (SPX) would be in a year, I would say there is an 85% chance it will be higher than its current level of 1108, 70% it would be higher than 1160, 50% higher than 1200, etc.

Options traders must not only decide if they are bullish or bearish, but also ask the question, “How bullish or bearish?”  Based on the answer, traders should then use the appropriate strategy that coincides with this sentiment. If you asked me where the the SPX would be by December 31, 2009, my outlook might look like a 20% chance it will be at its current level, 5% chance higher than 1160, and so on.  For me to just go out and buy SPX futures or SPY shares might not be the best use of my money based upon my hypothesis.

Let’s go back to real estate. Let’s assume that you currently wanted to invest in the Florida real estate (which is still on shaky ground) because you believed values were on the rise.

1.  Would you go out and just start buying up tracks of housing? Paying full price?

2.  Would you buy (call) options and pay the home seller a nominal amount to purchase their house slightly higher than it is now for the right to buy it at that price for the 18 months (If the price rises above your call option price, you get to keep that profit, while only risking the premium you paid for the call option)?

3.  What if there were housing futures you could buy options on that allowed you to make 30% annually as long as the housing market prices stays stable (Maybe a housing ETF such as the UMM or HGX)?

Around 80% of you probably gravitated toward the third section, while 18% could have selected the second question, and 2% would just go buy houses.

What I find interesting is that 85% investors use Section #1 to invest in the stock market.

Think about this concept and run it by your family at the Thanksgiving table. Give them the quiz and see how they respond.  Chances are that if they understand the second and third concepts, they will chose those selections.  The folks who fail to understand the concept will gravitate toward the first section, which is the one with the highest amount of risk and exposure, and it is this option that causes people to panic more so than the others, because of the risk of losing considerably more money.

Options can be powerful risk-reduction tools, so learn them!

Happy Thanksgiving! I’m off to bake some sweet potato pie!