Expansion At Any Cost Can Weigh Down Gains for Investors
The headline appears ominous. “CarMax Forges Ahead With Store Expansion, Expense Woes Stay,” according to ZACKS. The details follow a potentially classic “good news, bad news” scenario. The good news is that there could be growth in the long run. The bad news is that there could be concerns in the short run.
This is the type of dilemma investors may face from time to time. Managing a public traded company is a challenging job. The goal is to manage for the long run ensuring the success of the company in the future years while balancing short term concerns about costs against that goal.
It can force management teams into tough decisions. For example, there is the question of when to add stores and when to focus on improving quarterly earnings. A focus on quarterly earnings can boost the stock price in the short run. A focus on growth can boost the company in the long run.
CarMax (NYSE: KMX) appears to be facing this dilemma and management appears to be deciding to focus on the long term. This decision does seem to have affected the stock which has run into resistance and fallen in recent weeks.
Growth for the Long Run
As ZACKS explained, “CarMax operates as a specialty retailer of used and new vehicles. The Richmond, VA-based company pursues an aggressive store expansion strategy.
During third-quarter fiscal 2019, the company opened four stores in new television markets of Wilmington, NC; Lafayette, LA; Corpus Christi, TX; and Shreveport, LA. Additionally, the company is investing in its digital platform to drive traffic.
CarMax focuses more on the used-car market. The company holds a competitive advantage in used vehicle retailing due to high degree of customer satisfaction on account of low prices and a customer-friendly sales process.
In the third quarter of fiscal 2019, CarMax posted earnings per share of $1.09, up 34.6% from a year ago. Earnings surpassed the Zacks Consensus Estimate of $1.01. Revenues however slightly missed the Zacks Consensus Estimate but improved year over year.
Meanwhile, high selling, general and administrative expense is a serious concern. In the first nine months of fiscal 2019, CarMax’s selling, general and administrative expenses rose roughly 7.7% year over year to $1.3 billion.
This can be mainly attributed to expenses pertaining to store openings. Increasing investments in technologies and digital platforms, and escalating compensation expenses are adding to the expenses.”
This expansion does bode well for the long run but traders tend to focus on the short run and several factors point to weakness in the stock.
The long term chart of the stock shows that there is a down trend that developed after a double top pattern and further declines are likely as support appears to be broken.
Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.
A Bear Call Spread in KMX
For KMX, we could sell a February 15 $62.50 call for about $1.60 and buy a February 15 $65 call for about $0.70. This trade generates a credit of $0.90, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $90. The credit received when the trade is opened, $90 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $160. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($90).
This trade offers a potential return of about 56% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if KMX is below $62.50 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $160 for this trade in KMX.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.