I’ve written a series of articles highlighting ways to leverage options trading to augment a long position or potentially entering into a position in Netflix Inc. (NASDAQ:NFLX). I’ve highlighted ways in which one can layer in covered calls to mitigate risk in a long position as well as utilizing secured puts to enter into a position at a lower price or avoid owning the stock altogether while making money. Whether you’re investing or trading in Netflix, it’s difficult to own the stock without an options strategy to augment the long position or prospective position. I’ll discuss a covered call/secured put combination strategy to unlock additional value, mitigate risk and generate income. I’ll break this strategy out into legs to exemplify the power of options when dealing with an intrinsically volatile stock with significant upside potential such as Netflix.
There’s no disputing the fact that Netflix has an outrageous valuation and a wide range of intrinsic volatility, where swings of $8-$15 in one day are common. This intrinsic volatility is more pronounced during any major news story (i.e. expansion into international markets or subscriber price increases) and specifically around earnings announcements. As a result of the nosebleed valuation and volatility, in my opinion, options go hand-in-hand when committing capital to Netflix stock. Netflix is a high growth and industry disruptor stock thus investors are willing to pay a premium for this growth and technology innovation in the traditionally stagnant media space. However, the trade-off is that traditional metrics such as the price-to-earnings multiple (P/E ratio) and the PEG ratio do not apply. Due to its rapid growth, expanding critically acclaimed original programming (Narcos, Orange is the New Black and House of Cards to name a few), wrestling market share away from big cable companies, expansion into international markets, partnerships and its overall ubiquity, it's easy to see why investors are willing to pay a premium for this media disruptor. Due to these aforementioned factors, an options strategy may be an effective way to leverage and hedge this high growth stock while mitigating risk. Netflix offers high-yielding options premiums whether one owns the stock or attempting to gain a good entry point. This bodes well for those who are willing to leverage options trading to augment returns and mitigate risk throughout the volatile nature of Netflix’s stock. This could come in the form of covered calls and/or secured puts or a combination of a call/put strategy.
Note: This article discusses a covered call/secured put strategy to mitigate downside risk and generate income around trading Netflix stock. I provide my real life examples embedded around trading Netflix and its intrinsic volatility. I utilize options to extract additional value out of positions in addition to mitigating risk. I earmark a portion of my portfolio solely for options trading in more volatile stocks. The empirical example demonstrated here is part of my overall options strategy. There are numerous positions that I’ve written covered calls and puts on in which my overall position realized a net loss, despite the options income. I do not want to misconstrue readers into the belief that options are trivial in any sense.
The Covered Call/Secured Put Combination
I prefer to break out the options strategy into legs or compartmentalizing each segment in order to better understand the overall strategy in digestible pieces. An example of an options leg, in this case, would be if one owns the underlying security and writes covered calls against her position until the stock is relinquished. Hence the stock was purchased and sold (in between the purchase and sale, options were written against the position). The position was opened and closed with a realized gain or loss. Alternatively, when one doesn’t own the stock with respect to secured puts, the secured put option is sold and either the option is bought back and canceled or the stock is assigned. In the case of assignment, until the stock is relinquished with covered calls the leg will not be complete. Thus a leg constitutes money going into the investment and money coming out of the investment for realized gains/losses.
Netflix’s Volatility and Covered Calls – Leg #1
Netflix is a highly volatile stock with a 52-week range of $80-$133 per share or a $53 per share range. Layered within that range are swings of $10 per share or more (~10%) throughout the course of any given day. These swings to the upside or downside can be difficult to stomach especially after the most recent earnings announcement where the stock cratered by $15 per share in one day (~$100 to $85). To contend with this volatility, one can leverage her stock via writing covered call options to mitigate these swings while remaining long in this volatile stock. I initiated a position in Netflix at a price of $118.17 and sold a series of covered calls against the underlying position on the downward trend from ~$118 to the high $90s as detailed in figure 1.
Taken together, leveraging covered calls against my original Netflix position generated a realized income per share of $21.84 in cash. This equates to a realized 18.5% yield ($21.84/$118.17). This strategy has rendered my effective share price to $96.33 at the time of relinquishment ($118.17-$21.84). I reduced my average share price from $118.17 to $96.33 by executing options on my Netflix position. The underlying security was purchased at $118.17 and sold at $93.00 however I realized $21.84 in options income thus my loss was confined to $3.33 a share as opposed to $25.70 per share loss at the time. I mitigated my losses by 87% in this scenario albeit my overall position had resulted in a loss.
Layering In Secured Puts – Leg #2
I’ve since layered in the secured put side of options as part of my combination options strategy. This simply stated presents a situation where I sell a put option and receive a premium in exchange for the obligation to buy the shares at a specified price by a specified date. A recent contact that I sold was a secured put at a strike price of $105 in exchange for $10.16 per share while at the time the shares were ~$100. My thinking was, given the timeframe of the contract that Netflix would appreciate beyond the $105 level and I would free up the cash I had earmarked for the covered put and capture the $1,016 in cash premium. An alternative line of thinking was that in the event the stock remained above $95 then I’d acquire the shares at a gain since my effective share price would be $94.84 ($105 strike less the $10.16 premium). As expiration approached, I decided to buy back the contact at a gain so I would not be assigned the shares and I could use this freed-up capital to make additional moves. I was paid $10.16 per share, and I paid $8.89 per share to cancel the contact for a net gain of $1.27 per share without ever owning the shares. Since money was allocated to the option contract and the shares were not assigned as a result of my cancellation of the contract, this constituted the closing of an options leg at a profit.
Pending Secured Put – Leg #3
I’ve adopted a longer term strategy via secured puts where I don’t plan on owning the underlying security via assignment. In this scenario, I focus on far out dates with a strike price that is well within reach based on the 52-week range. I sold a secured put with a strike of $110 on 19-Aug-16 when the underlying security was trading at $96 per share. This contract provided two months’ worth or trading activity at a price of $15.56 per share. Any price above $94.44 is profitable ($110 less $15.56 premium) thus my strategy is to buy back the contract when the stock hits an uptrend approaching the $110 level to capture the majority of the option premium. As of this writing, Netflix is trading at $99.50, and with earnings coming up on 17-Oct-16 just prior to the expiration of the option contract (21-Oct-16), I plan on exercising a buy-to-close cancellation of this contract as Netflix typically catches an updraft heading into earnings.
I originally purchased the shares at $118.70 and wrote covered call contacts until relinquishment that generated a net income of $21.84 per share rendering my average share price to $96.33. I relinquished my shares at $92.92 per share thus $9,292 from the underlying equity plus $2,184 from options premiums equates to $11,484 total. Taken together, money going into Netflix was $11,817 and money coming out Netflix was $11,484 or a $394 loss (-2.8%). Adding in the profit that was made from leg #2, the loss is then decreased to $267 or -2.2% compared to a loss of -16.2% (trading at $99.50) had I kept the shares and sold them at the same price. With leg #3 pending, any strength to the upside towards the strike of $110 will render the entire position profitable despite my “purchase” price of $118.70 (Table 1 and Figure 2).
Table 1 – Comprehensive results of my call/put combination strategy in mitigating downside risk
Whether you’re investing or trading in Netflix, an options strategy can be highly beneficial in augmenting this position and mitigating risk. As a result of its valuation and volatility, in my opinion, options are the ideal defense when deploying capital to Netflix stock. Thus far I’ve confined my realized losses to -2.2% compared to -16.2% with the traditional buy and hold strategy as a result of my call/put combination or alternatively, an 86% mitigation in losses. Factoring in my pending contract it is likely that my overall position will be positive as Netflix breaks through the $100 mark. Due to Netflix’s intrinsic volatility, an options strategy may be an effective way to leverage and hedge this high growth stock while mitigating risk. This could come in the form of covered calls and/or secured puts or a combination call/put strategy as I outlined above. Netflix’s recent string of earnings disappointments highlights the value of an options strategy to mitigate losses and smooth out drastic moves in the stock price.
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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.