The July 27 battle in housing stocks is a preview for rising volatility across the market in the days ahead

07/27/2009 5:51 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

It's going to be one bloody battle.


Bulls are bidding up the shares of home builders on reports that U.S. new home sales climbed 11% in June. That's the biggest jump in eight years.


Last week,before the news, short sellers had been loading up on these shares betting that the sales would't increase or that if they did they wouldn't continue to increase and that shares will plunge. (Short sellers make money by borrowing shares from other investors, selling them, and then buying shares at a lower price to replace those they've borrowed.)


Round one goes to the bulls. The Philadelphia Stock Exchange HousingSector index climbed 3% yesterday and individual home builder stocks soared. Centex (CTX) climbed 9.12% on the day and Pulte Homes moved up 8.62%.


This is exactly the kind of huge volatility that results when bulls and shorts lock horns. And it's the kind of voilatility that investors are likely to see more of in coming weeks across the stock market as investors bet with their cash on whether this rally will keep on chugging or go down in flames. You can get a sense of that wider battle to come by looking at yesterday's housing skirmish.


It's no coincidence that some of the stocks that went up the most in the housing sector on July 27 were precisely those that were most heavily shorted. For example, on July 24 shorts bought 27,000 puts in Centgex (CTX). Puts are options which allow the owner to sell the stock at a future date at a fixed price and therefore bets that the share price will go down (which would make the right to sell at a higher price more valuable.). The acton was extremely heaviy in October puts that carried the right to sell at $8 before mid-October. Centex closed at $10.29 on July 27. Buyers of put options are betting on the stock to fall hard.


Oddly enough, the presence of so many bearish investors provides potential fuel for big moves to the upside. Traders who have sold short have to buy shares of the stock if they want to exit a position. Buyers of put options who would profit if the stock went down have to either buy balancing call options, the right to buy, to sell their calls if they want to get back to neutral or buy the shares outright.


Investors on the other side, the bulls, who are hoping that stock prices will climb, know that if they can just get a few bears to panic and buy, their buying will push up the stock price, creating more panic by the bears, pushing up the stock even further.


Add a catalyst like the government's July 27 report on a big upward swing in new home sales, and you can get a huge jump in the price of shares.


And that's what happened on Monday.


This isn't simply ancient history because similar battles are now being fought out all across the market. There's a sizeable minority of investors who believe the the current rally is over-extended at best and at worst built on false hopes and vapors.


Another round of good new in any of these sectors will produce the kind of buying panic that drove the shares of hoime builders today. When that happens, if yhou blink you'll miss the best of the run in the sector--and I don't advise you to chase one of these moments of volatility. But if the buying panic is strong enough, it will spread to related sectors and you might be able to catch one of those before it zooms out of sight. For example, it looks like the whoosh in shares of home builders to spreading to home-builder elated stocks such as Mohawk Industries (MHK), up 4.78% on July 27.


Why not chase these explosive rallies?    


 The huge jump in price that may have put these sectors on your radar screen to begin with is based on a fleeting squeeze on short-sellers. When the traders on the other side of this squeeze, the bulls who have made money by betting share prices would rise, see their profits, they'll sell and move on to the next trading opportunity. If you're not a trader and buy into one of these sectors because you think the big jump in price indicates some huge fundamental shift in the sector, you'll be the buyer that the trader sells to and you'll be left holding a lot of over-valued shares that are likely to drift slowly downward in price.


In the days ahead, I think we can count a big increase in volatility. That's not the same as a big increase in profits for the average investor.


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