New Trade AZO – Calling a Top, Risky Business

by Enis June 5, 2012 12:29 pm • Commentary

Before saying anything, please look at AutoZone’s chart in the last 5 years:

Since AZO began its incredible bull run in 2009, the stock has not been below its 200 day moving average for any significant period of time.  The chart is the epitome of the saying, “the trend is your friend.”

I don’t know much about AutoZone’s business.  I’ve seen their retail stores pop up all over my native Tulsa, and their stock chart speaks to a business growing by leaps and bounds.  The P/E ratio seems reasonable (16), and the business is easy to understand.  And I normally don’t like to short strength.  All of these factors would usually keep me away from trying to buy puts or put spreads in a stock like AZO.

BUT, I wanted to know, what odds do I get?  In other words, how cheap or expensive is the options market?  In AZO’s case, it’s very cheap, as the implied volatility is priced around 25 annualized volatility (refresher on implied volatility here).  Yet, the stock moved up almost 70% in 2010, about 20% in 2011, and was already up more than 20% at its highs this year (in less than 4 months).  And given its unbelievable run, 25% implied volatility seems grossly mispriced to me.  I think it should be closer to 35%.

Now, full disclosure, I have watched this stock for this whole bull run, and I have tried doing this twice in the last 2 years, in both cases watching my premium go to 0.  But I am going to try it again today, because this option pricing is cheap enough that I feel comfortable failing a few times as long as I hit the one winner that will render me profitable on the whole situation.  As I’ve said before, process over outcome, and the process almost demands that I make this trade again, no matter the outcome.

Here’s the trade:

TRADE: AZO ($376) Buy Jul 360/330 Put Spread for $4.80
  • Buy 1 Jul 360 Put for 6.96
  • Sell 1 Jul 330 Put at 2.16

Break-Even on Jul Expiration:

  • Profits between 355.20 and 330 make up to 25.20, max gain 25.20 with stock 330 or lower
  • Losses of up to 4.80 between 355.20 and 360, with max loss of 4.80 with stock 360 or higher

 

TRADE RATIONALE:

The risk/reward on this trade is better than 5 to 1 for a 15% pull back on a stock that is up 300% in the last 3 years.  I picked July because it captures the main upcoming macro events (Greece, FOMC, ECB talk), and I picked the 360/330 spread because 330 is where AZO started the year.  Again, this trade is an expected loser based on the odds, but I like the timing given the negative overall backdrop and the fact that AZO recently had its two largest volume weeks in the last 2 years, indicating more aggressive selling.

Calling a top is Risky Business, but sometimes you just have to say, WTF: