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This Auto Trade Could Deliver a Triple Digit Gain To Investors

This Auto Trade Could Deliver a Triple Digit Gain To Investors

The auto sector, at least for gasoline powered vehicles seems to have peaked. Auto sales have stalled for several years. That trend could now be affecting retailers in the sector. As The Street recently reported, “Shares of CarMax (NYSE: KMX) were falling … after the used vehicle retailer beat Wall Street’s sales forecasts but missed earnings expectations.

KMX daily chart

The Richmond, Virginia-based company reported third-quarter earnings of $173.2 million, or $1.04 a share, down from $190.3 million, or $1.09 a share, and missed analysts’ expectations of $1.14.

Bill Nash, president and CEO, said in a statement that the earnings drop was largely the result of a higher stock-based compensation expense, reflecting an increasing share price and a planned increase in third-quarter advertising expense related to the company’s omni-channel rollout and the launch of a new national advertising campaign.

The company said that advertising expenses increased $14.5 million due to both a new national advertising campaign launched in October and incremental marketing to support the omni-channel rollout.

CarMax said it expects fiscal 2020 expense per retail unit to be slightly higher than fiscal 2019.

Revenue in the third quarter increased 11.5% to $4.79 billion, beating Wall Street’s call for $4.68 billion.

Same-store sales rose 7.5%, beating analysts’ forecast for 6.2% growth, driven by strong conversion, which was aided by continued support from third-party lending partners, web traffic growth, and a favorable response to consumer initiatives.

Used vehicle sales climbed 13.6% to $4.03 billion, beating the consensus figure of $3.97 billion, while wholesale vehicle sales grew 1.2%, missing expectations of $625.5 million.

“Our retail sales strength was a direct result of our ability to execute well, with solid performance in operations, financing, customer progression, and marketing all contributing to our growth,” Nash said. “In addition, we benefited from a favorable underlying used car sales environment.”

The long term chart using weekly data shows that the disappointing earnings report comes as the stock is trading near all time highs. This could indicate the up trend that has been in place for more than a year is at an end.

KMX weekly chart

Or the decline could be a pull back within a long term up trend. Short term traders do not need to decide. They could use a strategy that benefits from a short term decline, assess the market action in a few weeks and decide how to place their next trade. This could be easier than determining the likely direction of the trend for the next year.

A 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.

bear call spread

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.

Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

A Bear Call Spread in KMX

For KMX, we could sell a January 17 $90 call for about $4.20 and buy a January 17 $95 call for about $1.45. This trade generates a credit of $2.75, 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 $275 The credit received when the trade is opened, $275 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $225. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($275).

This trade in KMX offers a potential return of about 122% 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 $90 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 $225 for this trade in KMX.