Forget Big Automakers; This is the Best Way to Profit in the Sector

We've seen record auto sales so far in 2014, but the headlines have also been filled with news of massive recalls by major automakers like General Motors (NYSE: GM) and Toyota (NYSE: TM).

In my mind, there's a better way to capitalize on the strength in the sector. I'm looking at a discount, high-margin, respected auto retailer that doesn't have recall problems, fares well in a weak economy and can adjust its inventory quickly to sell whatever cars are bringing in the most profits.

Despite the fact that shares have more than doubled in the past two years, CarMax (NYSE: KMX) is an interesting story that no one seems to be telling.

It's one of the largest standalone auto retailers and the largest used car dealer in the U.S. In fiscal 2014 (ended in February), CarMax increased its share of the 0-to-10-year-old used vehicle market by 16%, selling approximately 527,000 used cars. 

More importantly, it has a flexible business model that has proven resilient in tough markets. Nearly 60% of its business is retail, but the other 40% is derived from wholesaling the cars it buys on the cheap from customers (via their own auctions), financing income and service on the cars it sells. These alternate means of income help profits remain stable when the retail market softens.

The company has seen substantial earnings growth, and that trend is likely to continue as analysts expect double-digit sales increases in the next two years. 

Additionally, it is adding stores and investing heavily in marketing. It opened four new stores in the most recently reported quarter and has plans to open 13 new stores this year. This should increase profitability and customer reach. 

On June 20, KMX surprised investors with much better-than-expected results, and shares surged 16.5%. In addition to record revenues and earnings, management issued positive guidance. Since then, many analysts have changed their tune and upgraded the stock.

KMX Stock Chart

While I believe the longer-term story is compelling, we are going to keep our eyes set on the next two to three months and use options to amplify our profits. 

The recent pullback to the upper gap support of $50.25 allows an advantageous entry with our target being just above the 52-week high at $54.

KMX Call Option Trade

Today, I am interested in buying KMX Oct 46 Calls for a limit price of $5.70.

KMX Call Option
Risk graph courtesy of tradeMONSTER.

This call option has a delta of 80, which means it will move roughly $0.80 for every dollar that KMX moves, but it costs one-tenth the price of the stock.

The trade breaks even on expiration at $51.70 ($46 strike price plus $5.70 options premium), which is 1.5% above current prices.

While the move to $54 could come quickly, I am buying some extra time due to the fact that the market is overbought. Even though it appears that equities will continue to melt up, it's better to be safe than sorry.

For our stop-loss, we are going to use the 200-day moving average (MA), which is currently around the $47.50 area. The post-earnings gap put KMX firmly above that level, and a three-day violation of that average may constitute a change in trend and will prompt our exit.   

Recommended Trade Setup:

-- Buy KMX Oct 46 Calls at $5.70 or less
-- Exit position if KMX trades below the 200-day MA for three days
-- Set profit target at $8 for a potential 40% gain in three months

If you have a question or comment about today's strategy, please send it to editors@profitabletrading.com.

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