Why Technical Analysts Worry When a Stock Is Too Popular
Popularity is a double edged sword for a stock. In this context, the popularity of a stock is considered to be the broad sentiment associated with the stock, not the company. Sentiment can not be directly measured but it does effect a stock price.
When sentiment is bullish, bad news is shrugged off by traders and a stock price can rally. If sentiment is bearish, the stock price can fall even in the face of good news or strong fundamentals.
Popularity represents a double edged sword because some level of popularity is bullish for a stock while too much is bearish. In a sense, popularity is a proxy for investor interest. When some investors are interested in a stock, they may buy. But gains require significant buying and significant popularity.
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But, when too many investors are interested in a stock, it can become overvalued and then, the slightest bit of bad news can send a stock price plummeting. That’s what happened to Netflix (Nasdaq: NFLX).
Netflix Misses On a Key Metric
NPR had the story, “Netflix Falls Short On Subscriber Target, Spooks Investors.” The details are the same on thousands of web sites:
“Netflix says its faulty forecasting caused it to miss its target for new subscribers, falling short by more than a million even as it reported quarterly earnings that beat analysts’ expectations.
The streaming service that has ventured in recent years into original productions, such as The Crown, House of Cards and Stranger Things, reported a profit of $384.3 million, or 85 cents a share, up from 15 cents a share the previous year. Revenue was up 6 percent to $3.9 billion.
According to The Associated Press, “The company gained 5.1 million subscribers worldwide during the quarter, more than 1 million below the number that management had believed it could. It marked the first time in a more than a year that Netflix hadn’t exceeded its subscriber growth projections. As of June 30, Netflix had 130 million subscribers, including 57.4 million in the U.S.”
In a letter to shareholders, Netflix called its second-quarter performance “strong but not stellar.”
CNBC writes, “Some analysts were worried the company could not sustain its share price growth, which is over 100 percent year-to-date. They also raised concerns as competitors like Amazon ramp up their streaming efforts, while others like Disney and AT&T are prepared to invest in more digital content. Netflix is expected to spend up to $8 billion this year on 700 original series.”
In its earnings statement, Netflix said, “YouTube and Netflix are two leading global (ex-China) internet entertainment services. HBO and Disney are evolving to focus on internet entertainment services. Amazon and Apple are investing in content as part of larger ecosystem subscriptions.”
“Each of these firms has unique content and is striving to find the best creators from around the world to entertain its viewers,” according to Netflix. “There has never been a better time to be a creator or consumer of content.”
Traders Sell the News
The reaction to the news began as soon as the results were released. NFLX fell 15% in the afterhours trading.
But, the longer term chart shows that NFLX was due for a pullback. It had simply become too popular and was most likely over owned after its large gain.
NFLX is now unlikely to bounce back. That means an options strategy could be useful to generate income from the high priced stock.
A Trading Strategy To Benefit From Weakness
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook for the short term, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in NFLX
For NFLX, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an August 17 $390 call for about $14.00 and buy an August 17 $395 call for about $12.70. This trade generates a credit of $1.30, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $130. The credit received when the trade is opened, $130 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $370. The risk is 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 ($130).
This trade offers a potential return of about 35% of the amount risked for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if NFLX is below $390 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 $370 for this trade in NFLX.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.