Name That Trade – Netflix ($NFLX): Wet Hot American Bummer?

by CC September 28, 2015 11:42 am • Commentary

Earlier in my opening post (MorningWord 9/28/15: The Investment Landscape Is Moving Beneath Our Feet) I pointed out that if the S&P 500 (SPX) were to retest the October 2014 lows near 1820 (down about 4.25% from current levels) it would mark the first time since the start of the bull market in 2009 that the SPX matched a significant low from the prior year. That would also mean the uptrend in place since March 2009 would be broken and could possibly mark the end of the epic bull market run that as recently as May registered gains of 220%.  I also pointed out what I feel is a liquidation in a bull market leader, Biotech stocks, and that anyone telling you that this is a healthy rotation (XBI, S&P Biotech etf now down 30% from its all time highs in late July) is not seeing the forest from the trees. There is full on rolling panic, and it comes at a precarious time.

It’s our view that the rolling liquidation in bull market leaders, started with energy/commodities last year will ultimately hit your favorite tech stocks, Facebook, Amazon, Netflix & Google. (The kids call them FANG)  It seems unavoidable.

We think it makes sense to make defined risk shorts in these stocks as there is undue bull market enthusiasm around them.  If we are correct and that the bull market is ending, and the devastation witnessed in almost every asset class the world over will ultimately cause a re-emergence of the panic we saw in late August, then these FANG stocks will not be spared.

We want to target Netflix as we think this is the worst of the group (discussed last week in this space Name That Trade – $NFLX $TWX: Stream Dreaming).

There is no valuation support and in our opinion possibly a change in sentiment towards the company’s ability to continue its pace of quality original content with emerging competition and less differentiation for their platform. As for international expansion? We don’t want to poo-poo that, but if we are correct about the state of the global economy, it won’t matter for a at least a year or two.

And Apple. OMG. If they can offer a similar catalog and subscription through iTunes, and buy some original content and NFLX runs dry with their own content, then the stock will get cut in half.

The next identifiable catalyst is Q3 earnings on October 14th (after the close). The options market is currently implying about a 17% move in either direction. With the stock at $101, the Oct 16th straddle (the call premium plus the put premium) is offered at $17, if you bought that, and thus the move you would need a rally above $118, or below $84 to make money. NFLX has rallied 17.5% on each day following its last three earnings reports.  But I would also note that over the last 4 years the stock has declined on average nearly 19% on its October Q3 report:

from Bloomberg
from Bloomberg

$100 is the level, plain and simple, a beat and raise and the stock is back at $120, and a miss and guide down and the stock is $80.  The implied move, based on the volatility in the current market environment, the stock’s recent post earnings history, and the Q3 subscriber growth seasonality points to a stock that could easily be $120 or $80 in 18 days:

NFLX 1yr chart from Bloomberg
NFLX 1yr chart from Bloomberg

While the move seems fair, the implied move prior to the last three earnings events (in which it rallied on average 17.5% after) was only 10%.  So the options market is placing a far greater emphasis on this event than those in the last 9 months.  So what looks like an ok implied move now is actually quite expensive.

Netflix is actually showing some relative strength (e.g. today it’s down a half a percent vs Facebook being down 2.5%) so we don’t want to press it here. But we would sell into strength leading into its earnings event. (ideally in the 105-110 range) We’d also like to finance the purchase of directional trades as the implied move, even if realistic is probably too expensive to be naked long volatility. So here are some hypothetical trades (priced versus stock here) that we think make sense. Again, we’re not trading it today but will have it on our radar. So here are the trades:

Hypothetical Bearish trade capturing earnings:

Buy the Oct2nd weekly/ Oct regular 95 put calendar for 4.75

It’s tough getting involved in October expiration with vol so high, but selling this weeks options and importantly rolling them to next week’s can help. If the stock stayed here (or ideally was slightly lower) after this Friday we’d roll the short put to the Oct9th weeklies. And ideally those would also expire with the stock above 95 and you’d be left with a very dollar cheap put into earnings.

Hypothetical bearish longer term:

Buy the Oct/Jan 80 put calendar for 3.70

In this trade you’re selling just outside the expected earnings move on the downside, but owning just outside the move into January. If the stock went down to 80 on earnings this would be a nice winner, but even if it didn’t, as long as it didn’t rip higher you’d have plenty of time to continue to roll the front month short put. At 65, volatility in January is quite high and not something you’d normally want to own. But it’s high for a reason and a rolling calendar is probably the only way to take off some of that high vol risk.