Could Netflix Pull A GoPro?
Could Netflix (NASDAQ:NFLX) pull a GoPro (NASDAQ:GPRO)? Seeking Alpha contributor BayesianLearner raised that question in a recent article (Netflix Might Pull A GoPro This Year), basing his bearishness in part on his European perspective, arguing that "non-US Netflix sucks." In a recent article (Limiting Your Losses On GoPro), we wrote about how a hedge on GoPro significantly limited downside for GoPro shareholders:
[T]he stock is now down 57% since we wrote our October article; thanks to the hedge, GoPro investors were down only 15.3% as of January 14th.
In this article, we post an optimal collar hedge Netflix shareholders can use to limit their downside risk on the stock. First, though, we'll consider two more perspectives on Netflix's prospects, in addition to BayesianLearner's bearish one, and a quick explanation of hedging terms.
Netflix Earnings Estimates: Estimize > Wall Street > Netflix
As the chart below from Estimize shows, Netflix management's guidance was 2 cents per share for its upcoming release of its FQ4 2015 earnings; the Wall Street consensus was 3 cents per share; and the average estimate of Estimize's community of 338 Netflix analysts was 4 cents per share.
Portfolio Armor Potential Return
Every trading day, Portfolio Armor ranks every hedgeable stock and exchange-traded product (such as ETFs) by its potential return. Potential return, in our terminology, is a bullish estimate of how a security will perform over the next 6 months. As of Friday's close, the site calculated a potential return of 3.5% for Netflix. By way of comparison, this was the 2nd worst potential return the site calculated for "FANG" stocks: Facebook (NASDAQ:FB) had the lowest potential return, at 2.7%; Alphabet Class A shares (NASDAQ:GOOGL) were 2nd-highest, with a potential return of 14%; and Amazon (NASDAQ:AMZN) had the highest potential return of any security at 25.6%.
Explanation Of Hedging Terms
Recall that puts (short for put options) are contracts that give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). And calls (short for call options) are contracts that give you the right to buy security for a specified price before a specified date.
A collar is a type of hedge in which you buy a put option for protection, and, at the same time, sell a call option, which gives another investor the right to buy the security from you at a higher strike price, by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest price, while not capping your possible upside by more than you specify. In a nutshell, with a collar you may be able to reduce the cost of hedging, in return for giving up some possible upside.
Hedging Netflix With An Optimal Collar
We're going to use Portfolio Armor's iOS app to find an optimal collar to hedge Netflix below, but you don't need the app to do this; you can find optimal collars yourself by using the process we outlined in this article. Whether you run the calculations yourself using the process we outlined, or use the app, two pieces of information you'll need to supply (in addition to the number of shares you're looking to hedge) are your "cap" and your "threshold". "Cap" refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A logical starting point for the cap is your estimate of how the security will perform over the time period of the hedge. For example, if you're hedging over a 6-month period, and you think a security won't appreciate more than 8% over that time frame, then it might make sense to use 8% as a cap: you don't think the security is going to do better than that, so you're willing to sell someone else the right to call it away if it does better than that. For the example below, we started off using a cap of 3.5%, the potential return our site calculated for Netflix, but we raised it to 5%, because that was as high as we could raise it without raising the hedging cost. All else equal though, the lower the cap, the less expensive it will be to hedge.
The other term, "threshold", refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purposes of the example below, we've used a threshold of 7%. If you are more risk averse, you could use a smaller threshold, and you are less risk averse, you could use a larger one. All else equal though, the higher the threshold, the cheaper it will be to hedge.
As of Friday's close, this was the optimal collar to hedge 1,000 shares of NFLX against a >7% drop over the next several months, while not capping an investor's upside by less than 5%:
As you can see in the first part of the optimal collar above, the cost of the put leg was $10,550, or 10.14% as a percentage of position value. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was $12,500, or 12.01% of position value.
So the net cost of this optimal collar was negative, meaning an investor would have collected $1,950 more from selling the call leg than he paid for the puts.
Two Final Notes On This Hedge
- Note that, too be conservative, the cost of the hedge above was calculated using the ask price of the puts and the bid price of the calls; in practice, an investor can often buy puts for less (at some price between the bid and the ask), and sell calls for more (again, at some price between the bid and the ask), so, in reality, an investor would likely have collected more than $1,950 when opening this collar.
- Although the threshold on this collar is 7%, and thresholds are calculated to take into account positive hedging costs, they don't take into account negative hedging costs. So, the worst case scenario in this case, when taking into account the hedging cost, would be a decline of less than 7%: assuming, conservatively, a negative cost of 1.87%, the maximum drawdown here would be 5.13%. Similarly, the best case scenario wouldn't be 5%, the level at which this collar is capped, but 5% + 1.87% = 6.87%.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.