The real estate market is volatile and difficult to predict. As well, not all investors are looking for the same outcomes in that market. In this article, we will look at a few ways to trade real estate as a diversification method for your investments, and protect yourself against losses. But first, let's take a look at some of the common real estate indexes.

Discover the Indexes
Several indexes track real estate prices. For instance, the Dow Jones U.S. Real Estate Index represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The MSCI U.S. REIT Index represents a broad representation of REITs that generate a majority of their revenue and income from real estate rental and leasing operations. The FTSE NAREIT All Residential Capped Index measures the performance of the residential real estate, healthcare and self storage sectors of the U.S. equity market. The S&P/Case-Shiller Home Price Indexes track the price trend of typical single-family homes within designated metropolitan areas. (Learn more about in Understanding The Case-Shiller Housing Index.)

ETFs Offer Wide Diversification
There are a number of exchange traded funds (ETFs) that track real estate indexes. Each gives you a way to participate in a wide cross-section of real-estate-related equities. For example, ProShares Ultra Real Estate (NYSE:URE) looks to earn twice the daily performance, net of expenses, of the Dow Jones U.S. Real Estate index. Its holdings include interests in shopping malls, apartment buildings, hotels, self-storage warehouses and housing developments throughout the U.S.

Direxion Daily Real Estate Bull 3X (NYSE:DRN) seeks daily investment results, before expenses, of 300% of the price performance of the MSCI US REIT index. Its investments can include retail, office buildings, residential and industrial REITs. iShares FTSE NAREIT Resi Plus Cappp (NYSE:REZ) seeks to replicate, net of expense, the FTSE NAREIT All Residential Capped index.

And if you think prices will fall, you could short any of the above ETFs, or you could buy an inverse ETF, like Direxion Daily Real Estate Bear 3X (NYSE:DRV), that seeks daily investment results, before fees and expenses, of 300% of the inverse (or opposite) of the price performance of the MSCI US REIT index.

However, volatility in real estate prices tends to be regional. For instance, during the 2007 U.S. crash, parts of Nevada, Florida, Arizona and California were among the hardest hit markets, while other areas in the country didn't feel quite as much pain.

So if you're looking to make an investment that better reflects your local market, you might consider the next section.

Futures Index Contracts
You can buy futures index contracts on the Chicago Mercantile Exchange (CME). The contracts are based on home prices tracked by the S&P/Case-Shiller Home Price Indexes. These indexes are published monthly and have a base value of 100 (based on value of 100 in January, 2000). For example, if your area now has an index value of 200, it would mean a typical home increased 100% in value since January, 2000.

You have a choice of indexes on the following 10 major cities:

  • Boston (BOS)
  • Chicago (CHI)
  • Denver (DEN)
  • Las Vegas (LAV)
  • Los Angeles (LAX)
  • Miami (MIA)
  • New York (NYM)
  • San Diego (SDG)
  • San Francisco (SFR)
  • Washington, DC (WDC)

Plus, there is a National Composite Index (CUS) that is the stock-weighted average of all the individual metropolitan area indexes (the S&P/CSI Composite-10 index).

To see how this could work, let's imagine that you live in Miami and expect home prices in your area to drop. You could sell short a futures contract based on the S&P/Case-Shiller Metro Area Home Price Indexes for Miami (MIA). The contracts mature up to five years into the future. If you're right, and the index price drops below your originally agreed-upon price, you make money on the difference between the two prices. (To read more about futures, see Futures Fundamentals and Becoming Fluent In Options On Futures.)

Each contract costs $250 times the index. For instance, if the index in San Francisco is $200 at the time you want to buy, each contract will run you $50,000. And you can buy anywhere from to one to 5,000 contracts.

However, you don't have to put up the full amount when you buy a contract. You can use a performance bond (collateral) to leverage a huge amount of product for a fraction of its market value. (Keep reading about leverage in Margin Trading and What is the difference between leverage and margin?)

As you check futures contract prices, you'll see that they constantly change throughout the day, and each up or downtick represents 0.20 of an index point ($50) from your original agreed-upon index value.

Do you still want to invest in the real estate market, but options (available on the CME) are more to your liking? By buying call options, you get the right, but not the obligation, to buy a futures contract within a specific time period at a predetermined price. Consequently, when the option expires, if the market price is above the strike price, you'll get the difference.

And if you think prices will drop, put options give you the right, but not the obligation, to sell a futures contract within a specific time period at a predetermined price. When the option expires, if the market price is below the strike price, you'll make a profit.

Know Your Risks
According to the Federal Reserve, the home industry is a $21.6 trillion market, which is larger than the $15 trillion equities market. This represents about one-third the total of all major asset classes in the U.S. Therefore, it would make sense to include real estate as part of a well-diversified portfolio. (To learn more about these subjects, see The Federal Reserve:Introduction, 4 Steps To Building A Profitable Portfolio and Introduction To Diversification.)

However, the home industry as an asset class can involve risks, such as sustained declines in housing prices, and ETFs, futures, options and other alternative investments can provide protection against these risks. They offer an innovative way to participate in the real estate market without the expense and work of buying, managing and selling properties. (To learn more, see Exploring Real Estate Investments.)

Yet, there are risks in derivatives. For instance, with heavily margined futures or options you can lose more than you expected. And low trading volume among certain contracts could make it difficult to hedge your real estate holdings. Therefore, if you can't find a buyer for your contract, you have to keep rolling it over (which may mean increases in costs and commissions).

Also, the tracked indexes sometimes cover wide regions. For example, the S&P/Case-Shiller Home Price Index for New York City includes parts of CT, NJ and PA. Therefore, it might have nothing to do with home values in a certain neighborhood of Brooklyn.

As homes and other real estate investments become a greater part of individual portfolios, more hedging products will be sought out to reduce the risk of sudden declines. And you can expect financial institutions to come up with insurance-related investments, more ETFs and other investments to meet this need.