There is an old but useful expression used when buying a car. “Kick the tires and start the fire.” The phrase originated in the airline industry and has found its way into automobiles, serving as a reminder to look under the hood of a car before buying it. The same advice carmax.
On the surface, the stock appears to be fairly priced. CarMax trades at about 17 times expected fiscal year earnings, or $3.16 per share. This is roughly in line with the company’s forward multiple over the past 10 years. While this valuation may not seem unreasonable, the underlying fundamentals reflect a sharp squeeze on used car affordability. Mid-market consumers are already under pressure from soaring new and used car prices, and are seeing their situation made worse (literally) by severe financing headwinds. According to data from the St. Louis Federal Reserve, the average interest rate on used auto loans is 15.9% and the average loan term is 68 months. Even though used car prices have softened slightly, high borrowing costs keep monthly payments out of reach for many prospective buyers.
The operational metrics used to evaluate auto dealer performance show the impact. Cash conversion cycles are becoming longer, inventory turnover is decreasing, and the average number of days in lots is gradually increasing.
The trigger for a car sales boom remains elusive, as borrowing rates are unlikely to fall sharply in the short term. However, considering a reasonable multiple and stable cash generation, a sudden collapse is also not the basic case. This setting favors range-bound stocks with limited upside.
Strategy: November (Hedged) Short Strangle
Investors who expect KMX to remain within a defined channel can sell wide strranglers and buy out-of-the-money calls to neutralize upside tail risk.
Sell the November 50 put for $1.50 Sell the November 60 call for $1.00 Buy the November 67.50 call for $0.20 (upside hedge)
Key trading indicators and risk parameters
As a package, this three-legged structure collects a net credit of approximately $2.30 per share ($230 per spread, as each contract represents 100 shares) over six weeks (42 calendar days), or approximately 4.3% of the current stock price, or more than 37% annualized.
Downside breakeven point: $47.70, 12% below current price. Upward breakeven point $62.30, 16.5% above current price. Maximum upside risk is $5.20 per share ($520 per spread). That risk is limited above $67.50 ($7.50 spread width – $2.30 credits). Ideal target profit zone: between $50.00 and $60.00 short sale. In this case, you can keep the full $2.30 credit if you hold it until the expiration date.
Positioning rationale
The sweet spot is between $50 and $60 with an expiration date in November, when all three options expire worthless and you retain the full $2.30 credit. The downside is that this structure provides a buffer of nearly 11%. If KMX breaks above $47.70, the position carries standard put assignment risk, and investors who are comfortable owning the stock will be able to acquire the stock for $47.70 on a net basis (approximately 15x forward proceeds). On the positive side, a standard short strangle exposes a trader to unlimited risk associated with a short position in a stock. By buying the November calls at 67.50 with a portion of the premium received, we can maintain an attractive yield while limiting our upside risk to $5.20 above $67.50, protecting us from short-covering spikes and sudden unexpected macro easing/rate declines.
Disclosure: Tidal owns/holds all securities mentioned in the article.
All opinions expressed by CNBC Pro contributors are solely their own and do not reflect the opinions of CNBC, its parent or affiliate companies, and may have been previously disseminated on television, radio, the Internet, or another medium. This content is provided as part of editorial output for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any security or other financial asset. The content is general in nature and does not reflect any individual’s unique personal circumstances. The above may not be appropriate for your particular situation. Before making any financial decisions, you should strongly consider seeking the advice of a financial or investment advisor.
This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any security or other financial asset. The content is general in nature and does not reflect your unique personal circumstances. The above may not be appropriate for your particular situation. Before making any financial decisions, you should strongly consider seeking the advice of your own financial or investment advisor.
Click here for full disclaimer.
