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This Netflix Controversy Could Create High Income

This Netflix Controversy Could Create High Income

Trade summary: A bear call spread in Netflix, Inc. (Nasdaq: NFLX) using October $500 call options for about $19.35 and buy an October $505 call for about $17.30. This trade generates a credit of $2.05, which is the difference in the amount of premium for the call that is sold and the call.

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  • In this trade, the maximum risk is about $295. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($205). This trade offers a potential return of about 69% of the amount risked.

    Now, let’s look at the details.

    Netflix has been caught up in news about a recent release and this is a concern for investors according to Benzinga.

    “The controversy over the release of “Cuties” on NFLX has led to some uncertainty around churn and subscription numbers for the company.

    BofA Securities analyst Nat Schindler maintains a Buy rating on Netflix with a $575 price target.

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  • [But]Schindler named several headwinds that he said could impact Netflix shares going forward.

    The headwinds are increased competition from platforms like Disney+ and Peacock; the large influx of new subscribers in the first half of 2020; the return of live sports; the return of movies; and elevated churn from “Cuties.”

    Schindler looked at data from ANTENNA and Google Trends to see how Netflix churn could be playing out.

    ANTENNA shows churn in August was at a monthly rate of 2.97%. That’s higher than the July figure of 2.72% and August 2019’s 2.93%.

    After the controversial “Cuties” was released, the term “Cancel Netflix” saw a huge spike and its highest figure ever on Google Trends, which the analyst said could have hurt September churn numbers.

    Daily U.S. cancellations tracked five times higher than average in the short period of time after “Cuties” was released, he said.

    That’s significantly higher than the 1.7x increase to the average when The Walt Disney Company’s (NYSE: DIS) streaming platform Disney+ was released, Schindler said.

    Data from SensorTower shows mobile downloads of Netflix have slowed, the analyst said.

    In the third quarter, downloads were down 2% year-over-year in the United States and up 1% year-over-year in international markets, he said.

    The third-quarter download figures are down 23% from the second, Schindler said.

    “We see added uncertainty for upside to guidance and believe investors are likely expecting the magnitude of potential upside to be less than 1Q/2Q.”

    This could all be bad news for the stock which is also churning near 52-week highs.

    NFLX weekly chart

    The daily chart shows a sell signal in the stochastic RSI, an indicator that is less prone to whipsaw trades than the traditional stochastic.

    NFLX daily chart

    Source: Symbolik

    To benefit from a decline, traders can short a stock. Shorting shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.

    A Specific Trade for NFLX

    For NFLX, we could sell an October $500 call for about $19.35 and buy an October $505 call for about $17.30. This trade generates a credit of $2.05, which is the difference in the amount of premium for the call that is sold and the call.

    Remember that each contract covers 100 shares, opening this position results in immediate income of $205. The credit received when the trade is opened, $205 in this case, is also the maximum potential profit on the trade.

    The maximum risk on the trade is about $295. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($205).

    This trade offers a potential return of about 69% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if NFLX is below $500 when the options expire, a likely event given the stock’s trend.

    Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $295 for this trade in NFLX.

    A Trading Strategy To Benefit From Weakness

    A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

    In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

    Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

    One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

    Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.

    The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

    bear call spread

    Source: The Options Industry Council

    While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

    You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.

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