Citigroup thinks AutoZone (AZO) may be idling

Earlier this week, AutoZone AZO shares were downgraded to hold from buy at Citigroup. The firm noted this was a valuation call, based on a 12-month price target of $224. That allows for roughly 9% of additional upside for the next year.

The stock has already been in a strong uptrend since February, gaining more than 30%. This downgrade contributed to sending the shares more than 2% lower, however, and the shares subsequently violated their 10-day and 20-day moving averages.

The retailer is expected to report earnings on or around September 21, which is shortly after September-series options will expire. Analysts are currently projecting per-share results of $5.37, a healthy increase from last year’s fourth-quarter results of $4.43.

For investors who think AZO will quickly recover from this downgrade-induced pullback and will resume its uptrend, we’ve outlined a potential bullish options strategy. For those in agreement with Citi’s neutral diagnosis, we’ve provided a neutral strategy example. Note that these are not buy/sell/hold recommendations, merely hypothetical demonstrations for educational purposes. The prices are taken as of Thursday midday, when AZO shares were trading at $204.47, down $1.30 on the day.

Bullish Option Strategy: Long Call

Investors with an optimistic outlook could scoop up short-term, out-of-the-money calls in hopes that the shares might snap back in the next few weeks. The September 210 calls are priced for $3.30, which is the most the investor can lose on this trade. If AZO shares are trading below the strike at expiration, the long call trader loses 100% of the initial investment. If the stock is trading anywhere between the strike and breakeven of $213.30, they will recover some of the premium. Above breakeven, gains are theoretically unlimited to the upside if the stock rallies.

Delta for this call is currently 39, which means that the option should increase by 39 cents for every $1 that AZO gains. Conversely, all other factors being equal, the option should lose 39 cents for every $1 decline in the underlying.

Remember buying out of the money call options is an aggressive strategy that requires the stock to move higher to cover the out of the money amount and the premium paid before the expiration date.

Neutral Option Strategy: Iron Condor

Those who agree with the “hold” thesis could potentially profit if the share price becomes stagnant. A December- iron condor trade can be created by shorting a bull put spread (selling the December 200 put, buying the December 190 put) and simultaneously shorting a bear call spread (selling the December 220 call, buying the December 230 call). The net credit for this four-legged condor spread is $5.50.

The investor keeps the maximum profit of $5.50 if AZO shares are trading in between the 200 and 220 strikes (the short strikes) when the options expire on December 17. The maximum loss, meanwhile, is capped at $4.50 and occurs if AZO is trading south of $190 or north of $230 at expiration; at expiry an iron condor can only lose on one side of the trade.

Breakevens for this strategy are $194.50 to the downside and $225.50 to the upside. At expiration, if AZO is trading between these levels, the condor should be profitable (remember to factor in commission costs when figuring out your own risk and reward).

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