Netflix Inc. (NASDAQ:NFLX) is a very controversial high-flying growth stock with a nosebleed valuation as measured by traditional metrics such as the price-to-earnings multiple (P/E ratio) and the PEG ratio. 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 easy to see why investors are willing to pay a premium. It's difficult to arrive at an accurate valuation based on traditional metrics for this media disruptor. Due to these factors and the difficulty of placing an accurate valuation on Netflix, options in the form of covered call writing may be an effective way to leverage this high-flier while mitigating downside risk. 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. This confluence bodes well for those who are long Netflix and desire to leverage options trading to augment returns and mitigate risk throughout the volatile nature of Netflix’s stock. Netflix’s recent earnings disappointment underscores the value of covered call writing to mitigate losses and smooth out drastic moves in the underlying security.
Note: This article is backing my long position while opportunistically and quantitatively writing covered calls to mitigate downside risk and generate income. I provide my real life examples embedded into my long position as Netflix is intrinsically volatile.
Leveraging The Volatility In Netflix
Netflix is a highly volatile stock and swings of $10 per share (or ~8%) throughout the course of a day are all too often observed. These swings to the upside or downside can be difficult to stomach. However, one can leverage his position via writing covered call contracts to mitigate these swings while remaining long this volatile stock. Utilizing biweekly or monthly contacts one can expect to obtain a cash premium of roughly 3%-6% with a strike price that's within 3%-5% of the strike price (tables 1 and 2).
Table 1 - Original purchase price $118.17 along with subsequent options contracts
Table 2 - Realized profits expressed net of fees
Taken together, leveraging covered calls against my Netflix position generated a realized income per share of $19.34 in cash while capturing a total option spread of 76% (premiums received – premiums realized). This equates to a realized 16.4% yield ($19.34/$118.17) over the course of five months. This strategy has rendered my effective share price to $98.83 ($118.17-$19.34). Assuming no options are active on this position, any appreciation beyond $98.83 per share is unrealized gains as opposed to any appreciation beyond the $118.17 purchase price. Details from each option contract can be seen below in Table 3.
Table 3 – Details of each option contract over the past several 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 (Figures 1 and 2).
Figure 1 - Google Finance graph is displaying a spike of $10 per share move in Netflix on January 6th, 2016
Figure 2 - Google Finance graph is displaying a drop of $10 per share move in Netflix on January 13th, 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 monthly basis.
Writing A Covered Call At Risk Into Earnings
In March, Netflix was stuck in a tight trading range between $90 and $100 per share. I decided to write a covered call when the stock reached $99 per share with a strike at $104 per share with an expiration date of 04/22/2016. Netflix was due to report earnings on 04/18/2016 just prior to the expiration of this contact. I wrote the option at risk knowing that if the earnings report turned out to be positive, the stock would likely fly much higher than the strike of $104. Due to the ~6.5% premium yield and accounting for the built-in upside of $5 per share I would be effectively paid $110.36 per share. However, I was writing this option at risk due to the increased uncertainty surrounding the upcoming earnings report. The earnings report would either move the stock up or down in a dramatic move. I wanted insurance in the event the report turned out to be negative and fortunately for me this strategy worked out well (Tables 1-3).
Granted, Netflix is a contentiously debated stock. However, the company has disrupted the entire traditional media landscape and has become ubiquitous throughout the US. Recently they announced that they've penetrated over 130 countries and that their worldwide expansion is well underway. Households are moving away from traditional cable and moving toward streaming services such as Netflix, Hulu and Amazon Prime for a fraction of the cost. This bodes well for Netflix and companies alike, especially as more original content is delivered along with more added value partnerships such as Disney. The nosebleed valuation is of concern. However, the growth and the fact that this company has penetrated millions of homes domestically and abroad gives way to an ongoing future for this company. In the meantime, as a long investor, writing covered calls in opportunistic scenarios may mitigate these drastic swings in the stock price while generating income. This is especially true given Netflix’s recent earnings disappointment and underscores the value of covered call writing to mitigate losses and smooth out drastic moves in this underlying security.
Thanks for reading,
The INO.com Team
Disclosure: The author has no business relationship with any companies mentioned in this article. The author has no business relationship with any companies mentioned in this article. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned.