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When Titans Falter: CarMax's Options Gamble and the Unforgiving Nature of Wall Street

Barchart - Fri Sep 29, 10:00AM CDT

It’s one of the oldest adages in the gaming ecosystem: the house always wins. That doesn’t mean the house always wins every hand or roll of the dice. But play long enough and eventually, the odds will stack decisively in favor of the casino. That’s why you need to know what you’re getting yourself involved in as the latest drama at CarMax (KMX) proved.

On Thursday, the used-car retailer reported results that were roughly in line with analysts’ expectations for the second quarter. Specifically, revenue came in at $7.07 billion, slightly pipping the consensus target of $7.03 billion. However, earnings per share landed at 75 cents, missing analysts’ estimate of 78 cents. Unfortunately, the year-ago comparisons were terrible, leading to a rush for the exits on KMX stock.

For example, the sales tally slipped 13.1% against Q2 of the prior fiscal year. Also, same-store sales fell 12.5% on a year-over-year basis, adding to concerns regarding the consumer economy. Though the Federal Reserve has made progress in its fight against inflation, reaching its target will be challenging. As well, consumers have had to contend with sharply rising borrowing costs, thus hurting demand.

Still, just prior to CarMax releasing its earnings results, a curious trade materialized in the derivatives market.

A Dubious Short Straddle on KMX Stock

On Sept. 27 – a day before the earnings release – likely a single institutional investor placed two transactions: selling (writing) 596 contracts of the Oct 20 ’23 79.00 Put and writing 790 contracts of the Sep 29 ’23 79.00 Call. The premium received for the puts was $224,724 and $202,892 for the calls.

From the looks of things, the setup appears like a short straddle.

Technically, the idea here is that the trader is hoping that there will be limited volatility in the underlying security, in this case KMX stock. That way, both options can expire worthless or close to worthless, thus enabling the speculator to pick up max premiums from both transactions.

However, the big “if” in all this is volatility. If shares move sharply in either direction, the short straddle could become an unprofitable venture. And if shares swing higher, that theoretically exposes the trader to unlimited risk since no upside limit exists for securities.

Without a mitigated approach – such as buying an out-the-money (OTM) call – to limit the upside risk, circumstances could get very ugly for the market participant.

Not Reading the Notes

What’s perplexing about the possible short straddle that materialized on KMX stock is the audacious nature of the transaction. Again, with short straddles, the desired result is a flat response in the underlying security. Otherwise, this trading setup can get blown up in the worst way possible.

However, the key question is, why would the trader initiate such a position?

It’s perplexing because CarMax gave no indication this year that its financial disclosures would lead to uneventful dynamics. For example, in April, the company posted better-than-expected profits, leading to a surge in KMX stock. In June, shares again spiked up on an earnings smash.

Pressed for an answer, I suppose the trader assumed that there would not be a hat trick and such a guess would have been correct. However, it was wrong to assume that the outcome would be a flat price action. No, KMX stock instead collapsed almost 14%.

An Odd Miscalculation

Generally speaking, retail investors should pay attention to what the smart money is doing. After all, big block trades can move the market; usually, the same can’t be said about the relative pebbles tossed about in the financial sphere. Still, even the institutional folks need to pay attention to the fundamentals.

Given that an enterprise like CarMax is highly dependent on economic conditions, elements such as high inflation and record-breaking credit card debt should play into the calculation of a high-stakes wager. And maybe such calculations did occur yet the trader decided that a short straddle represented the best move.

Nevertheless, it’s an odd miscalculation. Again, at no point did CarMax give any indication that its earnings reports would be uneventful. Further, with economic pressures rising, Wall Street looked to KMX stock as a sort of real-time demand barometer.

Up or down, KMX was going to move.

The Moral of the Story? Even Institutions Make Mistakes

If there’s one major takeaway from all this, it’s that institutional investors – no matter how smart they are, no matter how many resources they have access to – can make mistakes. It happens. Underneath the veneer, we’re all human.

Now, that doesn’t mean you should ignore options activity. Chances are, over the long run, the institutional investors get their transactions right more so than they get them wrong. However, it’s a reminder to approach the investment arena holistically.

Don’t get too caught up on any one indicator that you lose sight of the bigger picture.

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On the date of publication, Josh Enomoto did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.

Provided Content: Content provided by Barchart. The Globe and Mail was not involved, and material was not reviewed prior to publication.