With the economy taking a beating, used-auto dealership CarMax (NYSE: KMX) looks unappetizing, to say the least. Yes, KMX stock is up 31.5% on a year-to-date basis, but that serves to obscure the near-term picture. In the trailing month, investors have been rushing for the exits, enough so that the ticker has lost roughly 18% of value.
Again, you can blame the economy along with the Federal Reserve. Higher borrowing costs obviously aren’t helpful for the real estate market, but these days, many consumers are also struggling with vehicle purchases. It’s rough out there — it’s no surprise that KMX stock has floundered.
At the same time, the U.S. isn’t Europe — and by that, I simply mean that we’re really not a public-transportation-type of country overall. In many regions, it’s absolutely critical to have your own ride, and that’s where CarMax stock could potentially be interesting, especially following the latest series of drawdowns.
I get it: at prior lofty valuations, the premium associated with KMX stock simply didn’t make sense to most investors. CarMax is obviously worth billions of dollars, but it also needed a trimming if the current economic environment wanted such a reduction.
Still, as is sometimes the case, there’s always a possibility that the market overcorrects. Further, the news cycle is constantly shifting. Should positive developments materialize in the near future, CarMax stock could easily witness a contrarian sentiment boost.
And that’s really the argument at hand. No one’s denying that KMX stock presently looks like a terrible name — it’s awful, and it’s worrying. But as a debit-side options trader, we’re likely not going to profit from an observation apparent to everyone.
In other words, the question isn’t whether CarMax stock is in a bearish state. Rather, it’s whether the equity continues to be in this state or transitions to a bullish one.
Why the $55 Strike Price for KMX Stock Could Be in Play
In the last two months, CarMax stock has printed 10 weekly candlesticks on the technical chart. Within this series, only three of the candlesticks saw positive price action, meaning that most of the activity centered on drawdowns. Naturally, this fact will have an impact on the immediate perception of KMX, irrespective of its broader history.
Significantly, though, we also know through past analogs of this exact quantitative sequence (using data over the trailing five years) that when this event materializes in the technical chart, KMX stock tends to rise higher, especially over the next five to six weeks. Indeed, the median uplift resulting from this analog would be around a 10.2% move.
If we apply this assumption to the current CarMax stock price ($50.81), we may infer a median terminal target of around $56 on Nov. 20. That may give us some buffer room to attack the $55 second-leg strike in a debit options spread.
Specifically, I’m looking at the 52.50/55 bull call spread expiring Nov. 20. Here, the net debit is nominally small at only $110. Should KMX stock rise through and trigger the $55 strike on expiration, the maximum payout stands at $140, a payout of nearly 127.3%. Mathematically, this trade features favorable asymmetry, as you potentially would profit more than what you would put in.
Favorable asymmetry also comes into play when discussing the expected return on capital (ROC) for this CarMax stock trade. As circumstances stand, the wager is $110, the American-style odds are 127.27, and the win probability is 26.96% — a figure calculated by KMX’s probability distribution for the November monthly options chain.
Plug these numbers into an expected value calculator, and you get an EV of $42.60 below parity, translating to an ROC of -38.73%. Now, that doesn’t sound great at first glance, but there’s a little trick that could potentially change everything.
Probabilities for CarMax Stock are Up for Grabs
When you’re looking at an EV calculation, there are only two variables (beyond the amount of the initial wager) that are technically capable of improving your debit option trade’s ROC: you can either enhance your payout or your probability of success.
While the former category seems simple enough (by choosing a spread that offers a greater reward), the amount of probabilistic risk you incur will also change. Obviously, that’s because a higher strike target is naturally presumed to suffer from a lower probability of exceedance. Plus, Wall Street isn’t in the business of giving you an extra payout boost just because you asked for it.
So, with begging for a higher payout (while still maintaining the same amount of risk) being completely out of the question, the only other possible solution is to change the probability of the trade. That might seem like an absurd concept because there’s a common myth that probabilities are set in stone.
However, you are not bound by the probabilities that the Wall Street machinery feeds you, which is basically some derivative of the Black-Scholes formula. A key assumption of Black-Scholes is that the target equity will undergo a random walk between now and the expiration date. If KMX stock does end up trading randomly, then yes, we can rely on the aforementioned probabilities.
But the important meta question is whether or not that presupposition is justified for the equity at hand. I’m simply making the case that for CarMax stock specifically, this presupposition is not justified.
As I remarked earlier, KMX stock is currently structured in an extremely bearish state. Under this specific state, KMX tends to swing higher, transitioning from stark pessimism to contrarian optimism. Historically, this transition has been of such a magnitude that the November monthly 52.50/55 bull call spread may be realistically in play.
Quantifying the Potentially Coming Optimism
It must be said that the bullish options narrative for KMX stock comes with a warning: I’m basing my analysis on a very small sample size. As it stands, there just aren’t that many times when KMX suffers 70% session-wise drawdowns over a rolling 10-week period.
In fact, in the trailing five years, there have only been 16 such instances. However, CarMax stock has also exceeded the equivalent of the $55 strike on Nov. 20 a total of nine times. From an observational standpoint (within the dataset), we’re looking at a full-profit probability of 56.2%, not 26.96%.
Inserting this percentage changes everything in terms of ROC. Now, the 52.50/55 bull spread would have an EV of +30.50, which then dramatically raises the ROC to +27.73%.
Of course, history isn’t guaranteed to repeat, nor is it guaranteed to rhyme. But if you’re willing to take a shot on a speculative, contrarian opportunity before everyone else catches on, take a long look at CarMax stock.
