Netflix is showing strong ratings and also joined SwingTrader today. Let's look at a strategy with a slightly bullish outlook and a substantial profit zone on a mild pullback in the seasonally weak month of September. This strategy is called a broken-wing butterfly. We'll use puts in this case since the strikes will all be below the current Netflix stock price. This helps to reduce assignment risk.
According to IBD Stock Checkup, NFLX stock is ranked No. 1 in its group and has a Composite Rating of 97, an EPS Rating of 98 and a Relative Strength Rating of 89.
Broken-Wing Butterfly Option Trade
With a regular butterfly option trade, the wings are placed an equal distance from the short strike. With this broken-wing butterfly on Netflix stock, we leave a larger gap on a particular side.
This results in less risk on one side and more risk on the opposite side.
To set up the trade, we can do the following as Netflix stock trades just north of 700:
- Buy one Sept. 20 put with a 660 strike price at 5.45 per share.
- Sell two Sept. 20 puts with a 685 strike at 11.35.
- Buy one Sept. 20 put at a 700 strike at 17.25.
Notice that the put option with the upper strike price is 15 points away from the middle puts while the lower strike price is 25 points away from the middle puts. That uneven difference is what makes it a broken-wing butterfly. The risk will be nothing on the upside but larger on the downside.
Risk Vs. Reward In Netflix Stock
This broken-wing butterfly trade on Netflix stock brings in a slight credit of $10, which means there is no risk on the upside.
If Netflix stock finished above 700 at expiration, all the puts expire worthless and the small credit is yours to keep.
The maximum gain is $1,510 if the stock finishes at the short strike of 685 at expiration. It's multiplying 100 by the difference in the short strike and the higher strike plus the premium received for the entire trade (15 +0.10 = 15.10). If this were a debit, you would subtract the premium from the difference in strikes.
On the downside, the maximum loss is limited to $990 if Netflix stock finishes below 660 at expiration.
This is a risk-defined trade and you always know the worst-case scenario ahead of time. You calculate the maximum loss in this case by taking the difference between the short strike and the lowest strike and subtracting the premium received (10-0.10 = 9.90).
Managing The Trade
The ideal scenario for the trade is that NFLX stock stays flat initially and then slowly drifts lower to close around 685 at expiration. There is a large profit zone between 670 and 700.
The trade starts with a delta of 4, so has a slight bullish bias to start, but that will flip to a negative delta closer to expiry if the stock is still above 690.
In terms of risk management, I would set a stop loss of 20% of the capital at risk, or if NFLX broke below 670.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
