This Trade Could Net You 25%-50% Profits in 1-2 Months

Real estate may be about location, location, location, but investing is all about timing. Those who bought homes in 2006-2007 may still be underwater — if they were able to keep their home at all. Yet, buying those same properties two years later would likely have been a very good investment.

Fast-forward five years and the average home value in the U.S. is close to pre-crash levels, but the industry is slowing. Experts believe a small bubble has formed as overzealous investors leapt into real estate vehicles fueled by unprecedented monetary stimulus, aggressive loan programs and bank concessions.

While nearly 43% of all real estate transactions were in cash in Q1 2014, up from 19% in the same period last year, according to RealtyTrac, lenders have already begun pulling their aggressive lending programs and tightening requirements.

Big lenders such as Wells Fargo (NYSE: WFC), JPMorgan Chase (NYSE: JPM) and Bank of America (NYSE: BAC) control the lion’s share of the industry, and all are seeing a decline in business.

Today’s play is a smaller mortgage lender, PHH Corporation (NYSE: PHH), and if its recent earnings reports are any indication of the state of the mortgage market, then we might need to be more than a little worried. The company has missed earnings estimates in three out of the past four quarters by an average of nearly 60%.

PHH operates under two segments.

PHH Mortgage offers outsourced, private-label mortgage solutions to clients nationwide.

That means financial institutions, credit unions, corporations and government agencies can offer mortgages to clients without starting a mortgage lending division.

The other segment is PHH Arval, which is a fleet management company.

Earlier this month, PHH announced the sale of this business for $1.4 billion of which it will gross $750 million to $800 million with an after-tax gain of $250 million to $300 million.

Not only were investors unhappy with the deal, with the stock selling off nearly 7% the day after the announcement, but PHH now becomes a pure mortgage play.

The precarious fundamental future of PHH and the headwinds in the mortgage market, along with the charts, are what are compelling me to buy put options on the stock.

The fleet deal is due to close around July 31, at which point management is expected to release details on how it is going to use that cash. Analysts don’t see the cash as a large enough boon to the bottom line to justify the current stock price and have reduced estimates and issued a slew of downgrades.

Morgan Stanley (NYSE: MS) analysts, which are some of the most optimistic on the stock, believe PHH may use the fleet proceeds to offer a special dividend, reduce debt levels and aid in the growth of the remaining mortgage business.

But the thing is, the company’s mortgage business isn’t doing so well to begin with. It was the fleet business’ positive growth that helped offset the company’s losses.

In the first quarter, PHH showed a core loss of $0.32 per share versus a consensus estimate of earnings of $0.26 per share. The company saw a big drop in refinancing volume, with interest rate lock commitments down 18% from the prior quarter and down 65% year over year. Mortgage closing volume fell 22% from the fourth quarter and 45% from a year ago.

Experts expect these trends to continue as the Federal Reserve tightens its monetary belt and home prices near record highs.

Moving on to the charts, PHH has been “gappy” over the past month or so with all the news. We should be mindful of these gap levels and use them as guides for our targets and stops.

The bearish trend not only remains intact but was also given some added strength as a death cross formed on June 11 when the 50-day simple moving average crossed below the 200-day.

I would expect a bullish day in the near term, and then look for the stock to trade down just above the $22 area, and for the next leg down to take it to $21.

PHH Put Option Trade

Today, I am interested in buying PHH Aug 25 Puts for a limit price of $2.40. Be sure to use a limit order in this trade as the bid-ask spread is wide.

Risk graph courtesy of tradeMONSTER.

This put option has a delta of 74, which means it will move roughly $0.74 for every dollar that PHH moves, but it costs about one-tenth the price of the stock.

The trade breaks even at $22.60 ($25 strike price minus $2.40 options premium), which is 1.8% below current prices.

The first leg lower should occur quickly, and the $22.10 target should equate to roughly $3 in option premium, or a 25% profit. If this occurs, we will take 50% off the table. For the remaining portion of our trade, our target for the put options will be $3.60 for a 50% gain.

For our stop-loss, we are going to allow a 50% drawdown in the price of our option. If the midpoint between the bid and ask prices gets to $1.20, then look to exit the position.

If you have a higher risk tolerance, you could buy fewer contracts and not use a stop. PHH could get volatile around its earnings announcement at the end of July, and this strategy will allow for more flexibility in the trade.

Recommended Trade Setup:

  • Buy PHH Aug 25 Puts at $2.40 or less
  • Set stop-loss at $1.20
  • Set initial price target at $3 for a potential 25% gain in one month
  • Set secondary price target at $3.60 for a potential 50% gain in one to two months

Jared Levy

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Source: Profitable Trading