This is how bull markets usually pan out. They start with technology and growth stocks outperforming, as they are usually hit hardest during the prior bear market. Their earnings outlook also tends to bounce back quickly once things turn around. Then, as the rally begins to broaden out and interest rates start to decline, rate-sensitive pockets of the market join the party.
That’s exactly what we’re seeing play out at this moment. One area that is experiencing renewed strength is real estate, particularly real estate investment trusts (REITs). Real estate investment trusts either own or manage income-producing real estate, normally through directly investing in properties or the mortgages on those properties.
Investors can buy REITs directly, or may choose to further diversify by investing in REIT ETFs or mutual funds. There are several advantages to trading ETFs, including the ability to reduce market risk associated with owning individual stocks.
We can also trade options on ETFs, which is a great way to lower the inherent risk that comes with options trading.
The Vanguard Real Estate ETF VNQ is one example that heavily invests in a variety of REITs and has outperformed the broader market in July. As the Fed inches closer to its first rate cut of this cycle, investors are rotating into this rate-sensitive area.
StockCharts
Image Source: StockCharts
Option Essentials
Before we analyze today’s trade, let’s review some option fundamentals as a refresher. My mantra when it comes to option investing is “keep it simple.”
There is no need to worry about complex mathematical formulas or equations. Over the years I’ve found that the more complicated a strategy is, the less likely it is to work over the long run. Our aim is to utilize a strategy that is easy to follow and has a long history of profitability.
Options are standardized contracts that give the buyer the right – but not the obligation – to buy or sell the underlying stock at a fixed price which is known as the strike price. A call option gives the buyer the right to buy a stock, fund, or index, while a put option gives the buyer the right to sell the same. The investor who purchases an option, whether a put or call, is the option buyer, while the investor who sells a put or call is the seller or writer.
These contracts are valid for a specific period of time which ends on expiration day. There are weekly options, monthly options, and even LEAPS options which are longer-term options that have an expiration date of greater than one year.
Options consist of time value and intrinsic value. In-the-money options consist of both components. At-the-money and out-of-the-money options consist only of time value. At options expiration, options lose all time value.
Below we’re going to explore a call option purchase strategy. Purchasing a call option is bullish, with the goal to sell it at a higher price than we paid. The value of the call option moves up as the price of the underlying security increases.
Multiply Your REIT Returns
As we’ve seen, the VNQ ETF is in a price uptrend and is a good candidate for a call option purchase. When done correctly, trading options provides huge profit opportunities with limited risk.
In today’s trade, we’re going to target the VNQ August 16th expiration date and the 72-strike price. Purchasing this option gives us the right, but not the obligation, to buy 100 shares of the VNQ ETF at $72 on or before August 16th, which is a bit less than a month from now.
The table below displays the risk/reward profile for this trade. The VNQ ETF is currently trading at $89.35. We are purchasing 1 August 16 72-strike (yellow box) call at 17.6 points, which is the option premium (orange box). Since options account for 100 shares of the underlying ETF, the total cost for this call option trade is $1,760.
Zacks Investment Research
Image Source: Zacks Investment Research
The top (blue) row in the lower section shows the performance of the VNQ ETF based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our call option trade. We can see that if VNQ remains flat, this trade would encounter a minor loss of 1.4%. If VNQ moves up 5%, this trade will realize a 24% profit. If VNQ advances 15%, we would realize a 74.7% profit.
This illustration shows the inherent leverage that options provide. An ETF investor who bought 100 shares of the VNQ ETF would have to contribute $8,935, which is a much bigger investment. A 15% increase in the ETF price would yield a $1,340 profit.
On the other hand, in this example the option investor only needs to contribute $1,760 to control the same amount of underlying VNQ shares. A 15% move in the VNQ ETF would net a $1,315 profit on this option trade – a nearly identical profit amount with only about one-fifth of the investment!
Also note that this option contains relatively little time value. The 0.25 points worth of time value (red box) equate to just 0.2% of the underlying ETF price. A good way to manage risk when buying call options is to minimize time value and maximize intrinsic value, as time value decays rapidly in the days leading up to option expiration.
Bottom Line
As the latest rally begins to broaden out and interest rates start to decline, investors are rotating out of large-cap tech and into rate-sensitive and other depressed pockets of the market.
A great way to take advantage of this move is via low-risk call options on the Vanguard Real Estate ETF. This allows us to leverage REIT returns with the power of options. Be sure to keep track of the real estate sector as it appears ripe for a period of outperformance.
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