Netflix (NFLX) options are an interesting story with value for understanding the current nature of technology companies. It’s also a very good example right now of a stock on which you probably shouldn’t be selling puts.
Regular readers of Know Your Options are already familiar with my recommendation to include selling options into your bag of tricks – as long as you do it in a limited-risk manner.
One easy-to-understand option selling strategy is to sell out-of-the-money puts on a stock you’d like to own. You choose a strike based on the price you’d be willing to pay (below the current market price for the shares), sell the puts, and if the stock declines and those puts expire in the money, you buy the stock at your desired price and you also get to keep the entire premium on the options you sold.
The limited risk aspect of the trade is that if you already had the buying power to make the share purchase, there’s no more risk involved than if you simply purchased the shares outright. In fact, there’s less risk because you’ve both collected premium and bought at a lower share price.
If the stock rises instead, you won’t buy shares, but you’ll keep what you got for selling the options. You can buy them back cheaper as expiration approaches or simply let them expire.
This strategy works especially well if you can sell options after they’ve been bid up to higher implied volatilities by the market. The greater the premium you collect, the greater your potential profit.
Often, those opportunities come after a previously well-performing stock suffers a steep decline. You fundamentally liked the company, but the soaring share price turned you off. Now, not only are the markets are giving you an opportunity to buy it cheaper, but they’re also giving you an extra potential discount in the form of inflated put premiums.
Put prices tend to increase in IV terms when share prices decline.
I was exploring the possibility of doing this trade in Netflix this week, but the options markets didn’t cooperate. The experience is a good example of a situation when it’s not wise to write a cash-covered put.
Prior to the release of Q1 results this week, Netflix was trading around $550/share. That was about 5% higher YTD in 2021, and fairly expensive – with a P/E Ratio above 60X. Though the headline earnings number looked like a big beat – net earnings of $3.75 versus the Zacks Consensus Estimate of $2.98/share – investors were concerned about a big slowdown in subscriber acquisition numbers and sold the shares heavily.
At first I thought this might be an opportunity to sell some mid-term puts on a stock that just fell 10% and either collect a fat premium or buy the shares even cheaper.
But the premiums just aren’t very good.
Here’s a look at the May options with the stock trading close to $500/share:
The 450 strike puts are trading at an implied vol of just 30.54% and the bid price is $1.91. Apparently, the options markets aren’t expecting much more movement. That makes intuitive sense. The company has relatively consistent earnings because we know at the beginning of the quarter how many subscribers they have, how much they’re charging and how much they’re paying to buy or create the content they’re showing.
As we just saw in the most recent report, the real wild card with regard to the share price is the subscriber numbers – and we’re not going to see those again for another three months.
I need to have $45,000 in buying power to buy 100 shares of NFLX if I’m assigned on the puts, but I’m only going to collect $191 in options premiums if I sell the 450 puts. $191 is negligible relative to a trade that’s going to take $45,000 in capital.
The markets aren’t expecting anything else significant to happen to Netflix that might make my puts worth more money. Essentially the party ended on Tuesday with that earnings report. I want to get there when the party is raging!
If I were short a 450 put, the only way it seems that I’d get assigned to be buying the shares would be if something unexpected and very negative were to happen to NFLX in the next month – when I probably wouldn’t want them anymore.
That’s too much risk for a measly $191.
This space is usually about when and how to do an options trade, but it can be just as important to know when not to do a trade. There’s no specific math involved in this topic – simply basic common sense.
Don’t take big risks for puny rewards, in the options markets or anywhere else.
David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.