Netflix Free For Life If This Trade Works Out!

You’d have to have your head in the sand or be vacationing on Mars to miss all the headlines about Netflix right now. The company is one of the most talked about tech businesses in the world.

Some are calling it a huge success story and a company that can only continue to grow. It is fighting off increasing competition with its own award-winning content like Birdbox, the movie everyone is talking about.

Others are saying Netflix’s time as the industry leader is over. It is losing as much as 30% of its content portfolio as AT&T, NBC and others start their own streaming services. As much as 40% of their “hours watched” will go with that content.

While we could make either side of the argument all day, the real issue for Netflix is that of profitability. When everything else is going your way, investors are willing to wait a time before they demand real earnings. Just look at Amazon. The company went more than a decade spending more than it made to grow its sphere of influence before it throttled back enough to capture some of that revenue growth and keep it as earnings.

The problem, as some investors are now seeing, is that Netflix can’t just do that. The only route to actual and investment-grade profitability is to throttle back its content spending and increase subscription fees. Both of these would certainly be bad long-term moves in the face of increased competition. It’s already played with subscription fees to no bottom-line benefit.

Last year, the company hit a pothole in its upward climb. Investors started seeking alternative investments when the overall market started to slide in October. After all, Netflix is only attractive when everything else is going up.

Then, as you can see in the chart below, Netflix did find its way back into investors portfolios as the new-year rally began:


Unfortunately, that recovery looks like it just ended…

Weak Earnings Puts Netflix in the Crosshairs

Last night, the streaming leader announced its fourth-quarter earnings. It missed its revenue estimates by $20 million. For any other company wouldn’t be that large of a deal. But because Netflix investors are looking for enormous revenue growth and beating top-line expectations each and every quarter, that’s having a serious impact today.

Shares are down nearly 4% as we write. There’s certainly more room to fall from here. With this small but serious wake-up call, more investors could turn tail and run from Netflix’s stock. The only piece holding it together is its top line. This could be the last quarter it had before its real competition starts clawing at it.

By the end of 2019, AT&T, which owns Time Warner and all of its media, is going to launch its own rival streaming service. So will Disney. If you’re a parent with a small child, you likely know the benefit of a Netflix account with Disney’s shows. That’s gone in 2019.

This competition is only the start. NBC has announced its own plans for streaming. CBS is trying it out too. Hulu has always been in the background, but it’s not going anywhere. If you watch sports, you might be aware of ABC and its ESPN branch doing more streaming. Apple, of course, is still the large dark horse in the industry. If it figures out a way to really throw its weight into this fight, watch out.

The point is Netflix is going to be challenged. It’s doubtful that the company will collapse. It is the industry leader after all. But it will suffer some consequences for its revenue model.

How it ends up the year remains a mystery. But it is clear that in the short term, investors will continue to leave. This earnings announcement is going to hurt shares for a few weeks at the least. Pundits, financial journalists, and TV talking heads are already picking up this story. That message about increased competition and low earnings will continue.

Fortunately, there’s a way to play this weak outlook without actually needing to short NFLX shares or buy put options. In fact, this method let’s short-term bears collect their gains up front…

A Strategy For Short Term Bears

By using a bear call spread, traders can profit not only if shares of a stock plummet, but even if they don’t move at all. That’s because this is a net credit strategy. Here’s how it works.

Let’s say a trader believes Company XYZ is going to have a bad month. Its shares are trading at $10. The trader thinks they could be as low as $8. So, he enters a bear call spread.

He sells a $10 call on Company XYZ shares and buys a $12 call on Company XYZ shares. Since the sold call is close to the current share price, it would carry a larger premium. Meaning he profits on the difference in option premiums in this trade. That’s a net credit.

For him to profit, shares don’t have to go down to $8 like he expects. They can, and he’d still profit. But they only need to stay under $10 for the duration of the trade for the trader to keep his whole profit… which is the credit he received at the start of the trade.

Here’s what this kind of trade looks like:


Source: The Options Industry Council

Let’s look at a specific example of a bear call spread trade on Netflix…

A Specific Bearish Trade on NFLX

Netflix dropped below $340 per share following this recent earnings miss. It could and should remain below this threshold for at least a month as investors continue to leave in the short term.

So, a trader could sell a February 15 $340 call for $16.07 per share and buy a February 15 $345 call for $13.65 per share for a net credit of $2.42 per share. Since each call represents 100 shares of NFLX, that’s a total of $242 credited to the trader’s account.

That’s his total maximum gain. But he does get it right up front.

His total risk is found by taking the difference in strike prices ($345 – $340 = $5) and subtracting the entry credit ($5 – $2.42 = $2.58). That means this specific trade comes with a potential profit of 94% of its risk. That’s a very high return on a relatively safe trade.

Why is it so safe? Well, Netflix doesn’t have to do anything for the trader to keep that money. Shares don’t even have to fall. They could, and quite easily. But as long as they don’t go back above $340, the trader will keep that full $242 per contract.

If shares do rise, however, they’d have to go above $245 for the trade to result in a full loss of $258. But consider this. A $340 put option with the same expiration date currently trades for $15.35 per share. That’s $1,535 per contract. That would be the amount at risk if you were to use puts instead of this strategy. And you’d lose that full amount if shares trade at even $340.01 on expiration day.

Clearly, this bear call spread is less risky and comes with a known and upfront reward. That’s how a smart trader would play Netflix’s short-term weakness.

— The Option Specialist

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About the Author: The Option Specialist