Netflix is a high-flying growth stock with a sky-high valuation based on its price-to-earnings multiple. Due to its rapid growth, expanding original programming, wrestling market share away from big cable companies, expansion into international markets and its overall ubiquity, it’s difficult to arrive at an accurate valuation based on traditional metrics. Due to these factors and the difficulty of placing an accurate valuation on Netflix, options in the form of aggressive covered call writing may be an effective way to leverage this high-flier while mitigating downside risk and generating additional income. Netflix offers a confluence of volatility, liquidity and a high level of interest which gives rise to high yielding premiums on a bi-weekly or monthly basis which bodes well for options trading. Selling aggressive covered call options (i.e. aligning the strike price at or near the current price) to generate current income may augment overall portfolio returns while mitigating risk. This may be particularly invaluable if one is long a highly volatile stock such as Netflix. Below, I’ll walk traders through an aggressive options trading strategy leveraging Netflix stock a proxy.
The Aggressive Covered Call Example (NFLX)
If a stock trades at ~$124 per share on the open market and one purchases shares of the underlying security at $124 he can turn around and sell a covered call at or near the current price for a high premium. In this scenario, I wrote the call option at a $125 strike price and the buyer has the right to purchase the stock for $125 regardless of the stock price between purchase and expiration. If the stock rises to $150, the buyer still has the right to buy the stock for $125 prior to expiration. Since the payoff of purchased call options increases as the stock price rises, buying call options is considered bullish. In this case, the buyer believes the stock will increase in the near-term and buys the right to purchase the stock below where the buyer believes the stock price will be in the near term. When the price of the underlying stock surpasses the strike price, the option is said to be "in the money" and at this point, the buyer may exercise the option contract. Conversely, if the stock falls to below $125, the buyer will not exercise the option, since he would have to pay $125 per share when he can buy the stock on the open market for less. If this occurs, the option expires worthless and the option seller keeps the premium in the form of cash as profit. Since the payoff for sold call options increases as the stock price falls, selling call options is considered bearish. The seller believes the stock will trade sideways or move to the downside over the near term and thus is willing to leverage his shares while collecting premiums. A comprehensive overview is depicted in Tables 1 and 2, illustrating the example discussed above (Tables 1 and 2).
Bridging Theory And Reality
I’ll demonstrate the application of this theoretical strategy to the reality of the markets using Netflix as a proxy. I originally purchased NFLX at ~$124 per share and immediately turned around and sold a covered call at a strike price of $125 for a $4.51 per share premium or 3.6% realized gain over a two week period. As the shares moved down in price, I never relinquished my shares and was able to write another covered call on the same underlying security. This process was repeated and thus far through my recent contact, I’ve realized $13.33 per share or 10.7% realized a gain on my original position (Tables 1 and 2).
Table 1 - Original purchase price $124.42 along with subsequent options contracts
Table 2 – Realized profits expressed net of fees
Taken together, leveraging aggressive covered calls against my Netflix position generated a realized income per share of $13.33 in cash. This equates to a realized 10.7% yield ($13.33/$124.42) over the course of two months.
Opportunistic Spikes In Netflix Stock Bodes Well For Options
Netflix has risen and fallen by $10 per share in a single day multiple times (Figure 1).
Figure 1 – Google Finance graph is displying a spike of $10 per share move in Netflix on January 6th, 2016.
Writing a covered call into strength as was the case on Jan 6th, 2016 provides an opportunity for a higher strike price to decrease the chances or relinquishing shares of the underlying security. This provides current income while still maintaining a long position in the stock. Leveraging the stock during times of upswings bodes well for covered call writing. Netflix provides plenty of these scenarios to take advantage of on a bi-weekly and/or monthly basis.
A Word Of Caution
As of recent, the vast majority of stocks have fallen shapely and Netflix is no exception. Netflix closed at ~$102 per share on 21JAN16, translating into an ~18% decline from my original purchase price ($22/$122). Factoring in the $13 I received from premiums, I was able to mitigate my unrealized losses to from 18% to 7% ($9/$124). If the underlying security continues to fall perpetually, then the premiums will be less impactful and one may be stuck with an unpopular stock. If this situation arises, covered calls will not salvage your position entirely. One has to be cognizant of this risk even with a mitigation strategy such as covered calls.
Undoubtedly, Netflix is a contentiously debated stock however the company has disrupted the entire traditional media landscape and has become ubiquitous. As a result of Netflix’s high growth rate and penetration into international markets this stock is highly speculative and thus very volatile. This situation provides high yielding premiums and bodes well for those that are willing to initiate a long position while leveraging its volatility. The aggressive covered call option is a way to utilize options to mitigate risk, generate income via premiums and augment portfolio returns. This is a powerful way to generate income, accentuate portfolio returns if the stock of interest decreases in value, trades sideways or trends upward (without crossing the strike price threshold) as the premium will be kept despite any of these outcomes. To offset the risk of losing out on potential appreciation, the option seller is paid a cash premium that is deposited into the option seller’s account and never relinquished. Taken together, the owner of an underlying security can leverage his/her shares in a meaningful manner to mitigate risk and generate income to augment portfolio returns. This can be performed in an aggressive manner as long as the options are sold at or near the current price (in-the-money). This exercise can be repeated on a bi-weekly and/or monthly basis for healthy yields that can be very impactful to any portfolio over the long-term. Netflix will have to grow into its valuation however in the meantime as a long investor, writing covered calls in opportunistic scenarios way mitigate these drastic swings in the stock price while generating income.
INO.com Contributor - Biotech
Disclosure: The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses.