Trade High Priced Stocks
Netflix (Nasdaq: NFLX) reported earnings and the stock price jumped. This has been one of the best performing stocks in recent years and many individual investors have been unable to participate in the gains because the stock is priced at more than $300 a share.
The earnings report showed why NFLX has been a market leader. According to CNBC, “Netflix reported strong numbers for its first quarter…the streaming giant reported earnings per share and revenue that met analyst expectations. [I]nvestors cheered the company’s strong subscriber growth.”
The subscriber growth has been a factor in the stock’s long run performance.
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It was a great report and the news pushed the stock to new highs. But some analysts cautioned investors, warning that Netflix faced significant risks in the future.
Concerns About Spending
Jefferies equity analyst John Janedis said in a note Tuesday the company’s margins will be pressured by further content spending moving forward. He noted the company’s forecast for a 12% operating margin in the first half of this year seems optimistic.
Netflix is spending heavily on content and marketing. Janedis noted that free cash flow was negative $287 million for the quarter. He also noted he expects Netflix “will remain cash flow negative for several years” as it continues to invest in original content.
“The burn rate has been a focus,” he said. “It is also increasingly likely that this year or 2019 could mark the peak of [free cash flow] losses.” He questioned the company’s ability to meet its operating margin goals.
Barton Crockett, an analyst at B. Riley FBR, said Tuesday that while the company’s results were robust, “we still struggle with high valuation and lofty expectations.” Netflix stock traded at a price-to-earnings ratio of 219 on Tuesday, one of the highest among S&P 500 companies, according to FactSet.
However, Crockett also raised his price target on Netflix to $313 from $243. Janedis, the Jeffries analyst, hiked his price target on the Netflix shares to $312 a share from $236.
The analysts’ targets are near the current price. They both believe the company will remain a market leader.
“While we can’t responsibly recommend chasing Netflix’s equity here, we don’t see how one can escape seeing Netflix’s surprisingly durable growth as cautionary” for traditional TV, Crockett said.
The likelihood of a short term decline in the stock appears to be small now, after the strong rally on the earnings announcement.
A Trade for Short Term Bulls
As with the ownership of any stock, buying NFLX could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high prices stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for NFLX
For NFLX, the April 27 options allow a trader to gain exposure to the stock.
An April 27 $335 call option can be bought for about $7.00 and the April 27 $337.50 call could be sold for about $6.30. This trade would cost $0.70 to open, or $70 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $70.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in NFLX the maximum gain is $1.80 ($337.50 – $335 = $2.50; $2.50 – $0.70 = $1.80). This represents $180 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $70 to open this trade.
That is a potential gain of about 150% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.