NetFlix: Bullish and Bearish Option Plays for What May Be the End of the Party

| About: Netflix, Inc. (NFLX)
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By John Critchley & Christopher Yip

NetFlix (NASDAQ:NFLX), the warrior that conquered BlockBuster (OTC:BLOAQ) and the majority of video rental stores, is now seeking to expand overseas. Exploring markets in Latin America, Spain and the rest of Europe, it is quite clear this corporate giant is attempting to maintain a high growth strategy. With the subscriber growth rate beginning to lax in the states, NFLX CEO Hastings admits overall company growth can "get slow and stodgy." The decision to move to international markets is very reasonable but is also very costly, with the recent move to Canada serving as the best example. It requires huge sums of money to invest in other countries; and even after all the time, effort and money there is no guarantee that international operations will turn a profit. Operations in Canada are expected to profit the firm within a year, expectations that deem this particular international investment a success.

But what justifies NFLX's current stock price? Even after another disappointing job report pushed the market lower on Friday, this did not hold NFLX from shooting higher. Shares of NFLX ran as high as $276.24 in early trading on Friday's session, making a new all time high while the major indices each shed .5%. On Monday, before Apple's worldwide developers conference, the stock is taking a breather, down nearly 2.4%. Trading at a P/E multiple of 78, many investors and traders alike are questioning the driving force behind these price levels. A high short float of 21% is very telling that traders are not buying into this unjustified valuation and are instead piling into short positions. Perhaps recent buying is a signal that expectation in growth is already getting priced in. If this happens, we can expect further price inclination and even a violent pop above $280 and a run to $300 as shorts begin to cover their positions. But what happens after expectations are completely priced in and people are left waiting for good news from NFLX? This leaves NFLX shares at a very leveraged level and vulnerable to dismal macro and micro factors.

Recent stock behavior indicates that NFLX is trading not only in new territory but also in dangerous territory. Although it has a low beta of .43 and is perceived to be a relatively "safe" stock by many investors, its high debt to equity ratio of .85 combined with its future expenditures in foreign countries makes this highly leveraged company an extremely risky long-term investment. Should the foreign investments fail at becoming profitable, NFLX will have an extremely difficult situation in supporting itself with short term financing. All this and NFLX is only beginning to see competition stem from competitors such as Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL).

Add in the timeline they have left to renew subscription with Starz and one can really appreciate just how much NFLX has on its plate. With the Starz contract ending in quarter one in 2012, Starz has just requested the price of the renewal to be $350 million, topping estimates that they would only be looking for about $250 to $300 million. Starz made a similarly aggressive move earlier this year, announcing that new shows would not be made available to viewers using NFLX until after 90 days of the original release. It is obvious that NFLX is facing mounting pressures from multiple angles and how they navigate around the next few months is very crucial to the company's long-term health and stock price.

Options Play

Pricey high flying tech stocks like NFLX are seeing their implied volatilities crushed by option premium sellers. There is quite an interesting list of tech behemoths that are over $140.00 a share and that have seen their 30 day implied volatility hit 52 week lows. Besides NFLX, the list includes AAPL, GOOG & AMZN. This is occurring in spite of a sputtering economy and quite volatile non-domestic macro geo political events. There could be a few reasons for these somewhat dramatically low IV's.

  1. As the underlying appreciates, it becomes cheaper to sell naked puts than to buy the stock outright.
  2. The popular covered call strategy becomes more enticing for retail holders of Netflix underlying as the stock moves higher. This severely dampens OTM (out-of-the-money) implied volatility prices and also trickles down to overall implied volatility readings in NFLX.

But back to NFLX:

With NFLX hitting all time highs, the 30-day implied volatility of the options is hitting 52 week lows. The 30-day implied volatility is trading around 38%, far from the 52 week implied volatility high of 71.90% hit last year.

Let's take advantage of these depressed implied volatilities to either initiate a brand new short position or to protect existing gains.

Trade idea #1 -A Bearish Options Play

This may be an opportune time to initiate a short position through some put plays as the 52 wk low in 30 day implied volatility is usually a bearish sign indicating contentment and complacency in the marketplace. This sentiment can be quite dangerous as it often breeds false sense of security for the individual investor.

To find any decent implied volatility option plays, one must go out at least to the July '11 options, which presents a compelling medium term value.

The play: To take advantage of normal downside implied volatility skew and to benefit from any downward pressure in Netflix.

a) Buy July 260-240 put spread for $ 4.50. Receiving about 2.0% in Implied Volatility skew (buying 40.3 IV vs. selling 42.3 IV)

To finance this spread:

b) Let's sell the July 305 calls @ 4.10 This is approximately a 37.6% Implied Volatility.

Net debit: $.40

Risk: You will be Short the stock over $305. A 12.6 % upward move in NFLX over the next 5 weeks.

Trade idea #2- A Protective Options Play

For owners of the NFLX underlying, this may the time to protect some gains as the 52 wk low in 30 day implied volatility allows for ‘cheap protection.'

Let's find some protection through the summertime and the next earnings release on July 18. In order to accomplish this, one can go to the Sep '11 options, which presents reasonable medium term protection.

Trade idea -

The play: To capitalize on the depressed implied volatility in Netflix's put options.

a) Outright Buy September 240 puts @ 13.00 Buying 47.3 IV is reasonable for 3 ½ months protection plus an earnings release. This implied volatility purchase may appear to be much higher than the near term options, but remember there is earnings announcement premium baked( already priced) into these options.

To finance this purchase:

b) Let's sell the September 310 calls @ 11.10 This is approximately a 42.6% implied volatility. You are selling implied volatility in these calls at a skew discount to your put purchase. This is very normal and standard option pricing behavior. Do not let the skew dissuade you from putting on this type of trade.

Net debit: $1.90

Risk: You will have your stock called away from you over $310. A 15.4 % upward move in NFLX over the next 3 months.

Stay tuned ...

Disclaimer: We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .

Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.