3 Scenarios For The Netflix Sequel - Investors Get Ready For A 3-D Ride

Feb.22.12 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX), an online movie rental subscription service, has provided its investors plenty of drama in 2011.

After its share price increased 73% from $175.70 on December 31, 2010, to an intraday all-time high of $304.79 on July 13, 2011, NFLX shares plunged 79.5% from their all time high to an intraday low of $62.37 on November 30, 2011. NFLX shares then regained some lost ground by increasing 114% from their November 30, 2011, intraday low to an intraday high of $133.43 on February 7, 2012.

With NFLX shares currently at $117.40, as of the close of February 21, 2012, what's next?

When share prices exhibit substantial volatility as has been the case with NFLX, entry-point matters, regardless whether from the long side or from the short side. Investors and traders often express their views on share price movement in a 2-dimensional (2-direction) space: up or down. What is often neglected, and can possibly provide greater return, is the third dimension (direction): volatility with no directional bias.

Having no directional bias at the initiation of a trade does not necessarily imply that share prices will not move substantially in one direction or the other; it simply means an investor/trader can possibly benefit regardless of the direction. In addition, when entry-point is very tricky for a directional trade on a highly volatile stock, it is less tricky for a direction neutral trade. Furthermore, such direction neutral trade can be converted to a directional trade when an investor/trader has greater comfort upon the share price reaching certain pricing level.

In an article we published August 18, 2011, "Will the Netflix drama Have a Happy Ending," we suggested that with NFLX at that time trading at $232.24, investors may be best served by purchasing January 2012 strangles (puts with 180 strike and calls with 285 strike both expiring in the third week of January 2012) for the combined cost of about $30 for the strangle.

Following August 18, 2011, as NFLX tumbled to its intraday low of $62.37 on November 30, 2011, a purchaser of such strangle, depending on his exit point, could have booked a profit of as much as 400%, when the 180 put was in-the-money by as much as $117 (vs. the strangle purchase price of $30), with additional small residual time-value still left in the options.

At this stage, going forward, there are 3 scenarios for NFLX:

  1. NFLX can possibly continue to regain its lost subscribers, and possibly accelerate the addition of more subscribers through its cheaper streaming service, in addition to international growth such as the U.K. and other...
  2. NFLX subscriber growth can decelerate once again, and is unable to regain its momentum that it enjoyed prior to Q3 2011, as NFLX can also succumb to some competition, cost and pricing pressures
  3. NFLX can continue to maintain subscriber growth to possibly justify current share price levels, without providing much fuel in either direction

Trend-following entry-point is very tricky for a directional trade, especially when a stock is highly volatile and is trading at what seems to be unreasonable price levels either to the upside or downside. Similarly, volatility-following entry-point is very tricky for a non-directional trade, especially when volatility is pricey, and the stock is trading in the middle of a range, as opposed to the limits of one end or the other.

We believe that there is still too much uncertainty with regard to determining whether the above scenario 1 or scenario 2 will prevail. Although scenario 3 is a possibility, we believe that current pricing levels for some options would still justify a volatility trade. However, at this stage, and in case scenario 3 materializes, it may be best to establish a longer-term straddle position (at-the-money calls and puts), rather than a strangle position.

NFLX June 2012 straddles with a strike of 120 are trading at a price of about $33 ($18 for the puts and $15 for the calls). Although such price is expensive, investors may be rewarded by purchasing such straddle, and possibly looking at specific stock price levels to either delta-hedge the position to capture volatility moves, or to possibly convert the position into a directional position through the creation of synthetic option positions. This may be a good alternative to enjoy the 3-D ride.

Disclosure: I may initiate long option positions on the mentioned stock during the next 72 hours