Date Published: 2017-03-13
Netflix Inc (NFLX) has been on an historic run, claiming the top stock return spot for S&P 500 stocks in both 2013 and 2015. While the company has turned into a $60 billion enterprise, there is a very clever way to use options to profit from the run that isn’t immediately apparent, and quite damaging if unaccounted for.
Netflix Inc (NFLX) Stock Tendencies
While Netflix stock has exploded higher, the stock tends to move in chunks of momentum — or in English, when the stock rises, it tends to do so for an extended period of time, and the same can be said about a decline.
Selling an out-of-the-money put spread is one of the most common strategies to benefit from a bull market. The strategy has been exceptionally good for Netflix, but because of the stocks tendencies that we discussed above, we have to be clever in our approach. Let’s take a look.
First, here is how selling an out of the money put spread every week has done over the last three-years:
Even though Netflix Inc has seen that historic stock rise, it turns out that blindly selling an out of the money call spread has been remarkably poor — returning 3.9%. It’s almost unbelievable, but this is the reality of the stocks dynamics and how it affects options. But this is not the end of the analysis — it’s the beginning. The strategy we just looked at must be improved upon, and we start by addressing the risk.
First, we can see what happens if we avoid earnings — that is, while we sell a weekly out of the money put spread every week — when earnings come around, we simply skip that week. Here are the results.
By removing the enormous risk of earnings, the 3.9% return has turned into a 37.7% return — nearly ten-fold higher, while taking less risk.
We need to go further. Understanding the reality of Netflix stock dynamics leads to a strategy that lets the winners run, but cuts the losing short put spreads off early — it’s an approach to address the momentum based stock moves.
When selling a put spread the maximum gain is 100% but the loss could have a maximum of much worse than 100%.
Let’s establish a trading rule to remedy that:
In any week, if the short put spread loses 100%, let’s cut it off, and trade the next week. We are effectively removing a tail end of downside risk.
We can do this with the tap of the mouse:
And here are the results using a stop loss and avoiding earnings.
The original 3.9% return bumped up nearly ten-fold to 37.7% when we avoided earnings, and then rose another 15% when we cut the down side off with a stop loss.
We see a 13-fold increase in returns but there was no magic bullet, just a systematic approach based exactly on the dynamics of Netflix stock.
Is This Really Analysis, or Just Luck
Skepticism is natural — trading isn’t a game. We can prove to ourselves that this isn’t luck or happen stance. If our trading analysis is correct, this approach should work consistently for all time periods. That is, 3-years, 2-years and 1-year, across the board.
It turns out that this is exactly what we find. Here are the results, side-by-side, for two-years for Netflix Inc (NFLX):
No magic bullet — just objective data. An 80.2% winner, when shedding a bundle of risk by avoiding earnings and then using a stop loss, has turned into a 115% winner. We can even look at how this approach worked over the last year for Netflix:
Of all the time periods, this may be the most important. We aren’t seeing small gains turn into larger gains, we are actually seeing a substantial loser turn into a substantial winner all the while taking significantly less risk.
What Just Happened
This is how people profit from the option market — it’s preparation, not luck. Every stock has its own dynamics, we just need to identify them. This could have been Apple, Google, Bank of America, Coca-Cola or literally any stock, and even any ETF. We could have looked at long calls, covered calls, short puts, or anything that fits our comfort zone — and it’s remarkably easy.
To see how to do this for any stock, beyond Netflix Inc, for any strategy, with just the click of a few buttons, we welcome you to watch this 4-minute demonstration video:
Thanks for reading, friends.
The author has no position in Netflix Inc (NFLX) at the time of this writing.
Trading futures and options involves the risk of loss. Please consider carefully whether futures or options are appropriate to your financial situation. Only risk capital should be used when trading futures or options. Investors could lose more than their initial investment.
Past results are not necessarily indicative of future results. The risk of loss in trading can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition.
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