The used car market is stagnant. Here's how to profit anyway
Michael Khouw breaks down this short strangle options trade.
There's an old but useful expression used for buying cars: Kick the tires and light the fires. The phrase, which started in aviation but bled its way into automobiles, is a reminder to look under the hood and poke around before purchasing a car. The same advice would work for shares of CarMax .
On the surface, the stock looks fairly priced. CarMax is trading at roughly 17x fiscal-year expected earnings of $3.16/share. That's roughly in line with its 10-year historical forward multiple. While that valuation may not look stretched, the underlying fundamentals reflect a sharp squeeze on used-car affordability. Middle-market consumers, already pressured by high new and used car prices, see that compounded (literally) by severe financing headwinds. St. Louis Federal Reserve data puts average used auto loan APRs at 15.9% with an average loan term of 68 months. Even with used vehicle prices softening slightly, high borrowing costs keep monthly payments out of reach for many prospective buyers.
Operational metrics used to evaluate a car dealership's performance show the impact. The cash conversion cycle has lengthened, inventory turnover has slowed, and average days on the lot have crept higher.
Because borrowing rates are unlikely to drop precipitously in the near term, a catalyst for an auto sales boom remains elusive. However, given the fair multiple and stable cash generation, an abrupt collapse is also not the base case. The setup favors a range-bound stock with a capped upside ceiling.
Investors expecting KMX to stay within a defined channel can sell a wide strangle and buy an out-of-the-money call to neutralize upside tail risk.
As a package, this three-legged structure collects a net credit of roughly $2.30/share ($230 per spread, since each contract represents 100 shares), or about 4.3% of the current share price, over 6 weeks (42 calendar days), or more than 37% annualized.
The sweet spot is between $50 and $60 at November expiration, where all three options expire worthless, and you keep the full $2.30 credit. On the downside, the structure provides a nearly 11% buffer. If KMX breaches $47.70, the position carries standard put-assignment risk, allowing an investor who doesn't mind owning the shares to acquire them at an effective net basis of $47.70 (roughly 15x forward earnings).On the upside, standard short strangles leave the trader exposed to unlimited risk associated with a short stock position. By buying the November 67.50 call for a small portion of the premium received, upside risk is capped at $5.20 above $67.50, guarding against short-covering spikes or a sudden, unanticipated macro easing/rate decline, while still maintaining attractive yields.
Disclosures: Tidal owns/holds all the securities mentioned in the article.
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