/Netflix%20open%20on%20tablet%20by%20rswebsols%20via%20Pixabay.jpg)
Out-of-the-money (OTM) put options in Netflix Inc (NFLX) stock have attractive yields and provide a good buy-in strategy for value investors. This especially applies to near-term expirations, such as one-month out periods.
I discussed how cheap NFLX stock is in my Oct 20 article, “Netflix Stock Looks Cheap to Value Investors Based on Its Huge Free Cash Flow.” I projected that NFLX could be worth between $940 and $975 over the next year. Today NFLX is at $762.78 per share.
The problem is that this could take up to a year to occur. By shorting these OTM put options, the investor has the opportunity to set a lower buy-in price (in case NFLX falls) and still earn some income. The point is that by selling OTM put options the investor's only obligation is to buy shares, not sell any shares.
Moreover, the investor can repeat this trade after every expiration period. The trick is to do this in near-term expiry periods, to take advantage of the decay in extrinsic value.
Shorting OTM Puts in NFLX
For example, look at the Nov. 22 expiration period, 32 days from now. It shows that the $725 strike price put option, which is 5% below today's price (i.e., out-of-the-money), has an attractive premium worth short selling.
It is priced at $8.95 on the bid side. That means that the short seller can make an immediate short-put yield of 1.234% (i.e., $8.95/$725.00).
Here is how that works. First, the investor secures $72,500 or margin buying power for each put contract to be shorted. That is enough to buy 100 shares at $725.00, in case NFLX stock falls to that level
Then the investor can enter a trading order to “Sell to Open” one put contract at that strike price for expiration on Nov. 22. The account will then immediately receive at least $895.00 (more if the midprice is hit). That means the investor has made $895 on the $72,500 invested, or 1.234%.
Downside Issues
Now, as long as NFLX stays above $725.00 over the next month, the secured cash won't be assigned to buy 100 shares at $725.00. That is the absolute worst case, but it is covered by the collateral already secured (i.e., the $72,500 set aside - which is why this trade is called a “cash-secured short put” play).
But even if it does happen the investor's breakeven price is $725 - $8.95 or $716.05 per share (since the income was already received in the account). That is 6.2% below today's price, so it gives breathing room to the cash-secured short-put investor.
This trade can be repeated. So, if after three weeks the investor has made most of the income - i.e., the put price is now just 10 cents or so - the trade can be closed. That involves entering an order to “Sell to Close.” Then a new cash-secured short put play can be done.
That allows the investor to make additional income while they wait for the stock to fall to the targeted strike price. That's why this is a good way to set a buy-in price on a stock that could be worth substantially more over the coming year, like Netflix.
Wheel Strategy
However, if NFLX keeps falling the investor could end up with an unrealized capital loss. In that case, the investor would have to wait until the stock rises. Or they could sell at a loss and attempt to do the trade again to set a lower buy-in price. But that is not it.
The investor could also sell out-of-the-money “covered” calls. That would produce additional income. This could alleviate some of the loss or even set the sell price at the buy-in price or close to it. This is known as the “wheel” strategy, since, if the stock is sold using a covered call (i.e., the stock rises to the call price), there is now cash available to do another cash-secured put trade.
The bottom line is that NFLX stock looks cheap here. One way to play this is to sell OTM puts to gain additional income and set a lower buy-in price. In addition, for existing shareholders in NFLX stock, this play allows them to gain more income while also being exposed to any potential upside in the stock.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
