Netflix Inc. (NASDAQ:NFLX) is trading down more than 20% over the past few days after the decision to split its streaming and mail-order businesses led to the departure of many customers (and investors). While there are few investors looking to get in at these levels, existing shareholders looking to break even on their investments may want to take a look at this repair strategy.
Before We Get Started
Before exploring this strategy, it’s important to note that it’s designed for investors believing in a comeback. There’s no point in hanging on to a stock that is expected to perform poorly. If an investor believes Netflix is doomed to fall well below $100 per share, then the best decision is often to sell the stock and reinvest what’s left in another company with brighter prospects.
Meanwhile, investors sitting on a small loss (5% to 10%) may want to consider writing short-term call options at their break-even price rather than use the repair strategy. In this scenario, the investor collects the option premium and is only obligated to sell if they break even. Since the decline is only 5% to 10%, the option premium represents a significant portion of the decline.
How the Repair Strategy Works
The repair strategy consists of purchasing 12-month at-the-money calls – in the same number as your initial position – and simultaneously writing twice as many out-of-the-money 12-month calls. For instance, if you own 100 shares of Netflix, you’d buy one at-the-money call option and write two out-of-the-money put options. Of course, the times and prices are adjustable.
Since you’re writing twice as many options as you’re purchasing, the repair strategy can often be initiated at a break-even cost or even a net credit. No new capital needs to be committed to the position. Rather, you are simply obligating yourself to sell at a certain price in the future (the price of the option that was written) that is above the current price.
An Example for Netflix Investors
Suppose that a Netflix investor purchased 100 shares of stock at around $200 per share and is now sitting on a sizable 33% loss. The investor may want to consider the following two options (prices as of Sept. 20, 2011):
- 135 Jan 2013 calls trading at $42.40
- 200 Jan 2013 calls trading at $20.20
The investor decides to buy 1 of the 135 Jan ’13 contracts for $4,240 and sell/write two of the 200 Jan ’13 contracts for $4,040. The net cost of this position is just $200.
If Netflix continues to decline, the investor would be out the $200 as well as the continued losses on their original stock. But, if Netflix recovers to, say, $175 per share, then the investor would still have a loss of $2,500 on their original position, but it would be offset by a $4,000 gain on their 135 calls, to create a profitable overall position and a reduced break-even point.