Trading the Trend in Netflix (NFLX)

Netflix NFLX endured a bit of a setback in the days following its July 21 earnings announcement. The stock tumbled nearly 23% from peak to valley in just eight days and breached the 100 mark. Since August began, however, that downward pressure is only a distant memory. The shares have surged almost 40% from their July 29 bottom and hit a new all-time high of $134.37 intraday Friday.

The stock’s solid uptrend has transpired in the past week despite negative overall market tape. Despite this strength, however the covering analyst with Wedbush reiterated an “underperform” rating this week. He also nudged his 12-month price target higher by a dollar to $78, which still represents more than 40% of potential downside in the shares.

According to the OptionsHouse Research tab, just eight of the 29 analysts following the stock have named it a buy or an outperform. There is clearly skepticism surrounding the shares despite their seemingly indefatigable trend.

We’ve outlined two potential option strategies here – a long call for those who think the uptrend should continue and a broken-wing iron condor with a bearish skew. Remember these are not buy/sell/hold recommendations, merely examples of various strategies for educational purposes. The prices are taken as of Friday afternoon, when NFLX shares were trading at $132.29, down 76 cents on the day.

Bullish Option Strategy: Long Call (Stock Replacement Strategy)

Investors who have been long stock and bullish on NFLX, could consider selling the stock and “replacing” the long stock with a long in-the-money call. The stock replacement strategy has tax ramifications as does any sale of long stock, and is typically done when a trader wants to continue to own upside potential to the share price of a stock but is concerned that the shares might sell off.

The December 110 call, in-the-money by more than $20, is currently trading for $29.75. These calls have an intrinsic premium of $22.29 meaning the excess time premium is $7.46. So basically for a premium of $7.46, a trader can limit his downside in these shares.

You can also think of this strategy as follows: the trader who sells his long stock at $132.29 and simultaneously buys an in-the-money December 110 call for $29.75 has extracted $102.54 dollars of risk from his position. (A long stock position is at risk of a move in the shares to zero while a long call’s risk is also 100% of the premium paid, or $29.75 in this case).

At expiration, if the stock has fallen sharply and is trading anywhere below $110, the stock holder will continue to lose money to the downside; the most the options trader can lose is the $29.75 premium (plus commissions). Between the strike price and breakeven of $139.75, the investor makes back at least a portion of the initial premium paid. Above the breakeven price, gains are theoretically unlimited as the stock moves higher just like long stock.

The risk to the stock-replacement strategy is underperformance of $7.46 relative to the long stock if the shares appreciate between now and expiry. For example, the long stock will make money if the shares appreciate $2 to $134.29 by December expiry. The long call would be worth 24.29 only, a loss of $5.46 from the purchase price. Likewise to the downside, compared to long stock the long call underperforms until the stock drops below the strike price by more than the $7.46 in extrinsic value paid. This extrinsic or time value on the call will disappear at expiration.

Netflix (NFLX) long call profit and loss

Bearish Option Strategy: Skewed Iron Condor

Investors who have a bearish thesis on Netflix, at least for the short term, could consider a bearishly skewed “broken wing” iron condor. An iron condor essentially combines two credit spreads – one bull put spread and one bear call spread. This particular strategy can be built by trading the following legs:

Sell the September 115 put
Buy the September 110 put
Sell the September 130 call
Buy the September 140 call

For this four-legged strategy, the trader should collect a net credit of $5.00. The maximum profit is 100% of this credit, which is achieved at expiration if NFLX is trading between the short strikes (115 and 130). The condor can’t lose to the downside, as breakeven is 110 and anywhere below (the difference between put strikes minus the premium collected is zero). To the upside, breakeven is $135 and losses are capped at $5, if the shares were to rally above the $140 strike.

Netflix (NFLX) iron condor