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A Carmax Spread Trade to Put the Diagonal Condor Earnings Strategy to Work

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A Carmax Spread Trade to Put the Diagonal Condor Earnings Strategy to Work:

Carmax (KMX) announces earnings before the market opens on Wednesday, April 4, 2018.  If anyone would like to place the spread trade that we suggest below, the order must be placed no later than the market close on Tuesday, April 3rd.

Here are the numbers we compiled for KMX for the last eight quarters:

The prices in green are lower than the last pre-announcement price, suggesting that expectations are rising.  Most companies we tested show much many more green numbers than KNX.  Most of the time, KMX showed a high correlation between the actual results and what the stock price did after the announcement (while one might expect this would be universally true, our back-testing and personal experience has proved otherwise).  While the direction of the change for KMX was highly consistent (beating estimates resulted in a higher stock price, and vice versa), the magnitude of the change was not consistent.

In the June 2017 announcement, earnings were a whopping 23% above estimates, but the stock only gained 4% after they became public. In the next quarter, September 2017, earnings exceeded estimates by only 3% while the stock gained 10%.

KMX does not seem consistently beat or fall behind estimates.  This is a different pattern than we see in many companies who low-ball guidance, and then exceed estimates by a large amount quarter after quarter.  KMX does not seem to do this.

The average post-announcement stock price change for KMX was 4.9%.  This is less than the current option prices which have priced in a likely 5.7% change.  Someone who likes the stock might take advantage of the higher option prices and write an out-of-the-money call against their stock, and collect some nice premium in addition to some price appreciation if the stock manages to move higher.

We do not have a strong feeling concerning which way we feel the stock is headed after next week’s announcement other than that we think it will probably go in the same direction as the actual results compared to estimates. Since there is no clear pattern of how well the company does compared to estimates, this leaves us with a neutral position on the direction the stock might take after the announcement.

We have developed what we call the Diagonal Condor Earnings Strategy as our preferred options play prior to announcements.

Based on our neutral outlook on KMX, these are the spreads we placed for the upcoming announcement:

Buy to Open KMX 11May18 58 puts (KMX180511P58)
Sell to Open KMX 06Apr18 61 puts (KMX180406P61) for a credit of $.08  (buying a diagonal)

Buy to Open KMX 11May18 67 calls (KMX180511C67)
Sell to Open KMX 06Apr18 64 calls (KMX180406C64) for a credit of $.08 (buying a diagonal)

The net maintenance requirement (investment) on these spreads is $294 per pair ($300 – $16 plus $10 commission), and we have a net credit of $6 per pair in the account.

This is what the risk profile graph looks like after the market close on April 6, assuming that implied volatility (IV) of the May options falls by 3, from the current 33 to 30 (which is consistent with prior earnings week IV drops for 5-week-out options).

With KMX currently trading just below $62, the graph shows that we should end up with a gain if the stock ends up at any price between $59 and $67 on Friday, April 6th.  The sweet spot of the graph shows an approximate gain of $200 (about 66%) if the price ends up between $61 and $64.

If the stock fluctuates by its average post-announcement amount (4.9%), it would end up somewhere between about $59 and $65. In six of the last eight quarters, the fluctuation would have landed somewhere inside of this range, and in two of the quarters, it would not have.

To summarize our thinking, based on the level of IV for the options prior to the announcement (67) compared to IV for further-out options (33), investors do not get unduly excited about earnings announcements from KMX. The stock generally fluctuates after the announcement in the same direction as the results compared to estimates.  The company does not show a pattern of either consistently beating or falling behind estimates.  We believe this pattern is a perfect candidate for the options play outlined above which is essentially a neutral outlook, neither particularly bullish or bearish, but does best if the stock only fluctuates moderately after the announcement.

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