Netflix is one of the top stocks in the market right now and is a member of the IBD 50. But traders who think Netflix stock might consolidate around this level could look at a diagonal put spread to still profit.
This option strategy is an advanced one because it utilizes options over different expiration periods and different strike prices.
How To Profit From A Consolidation In Netflix Stock
For this diagonal put spread, we'll sell an out-of-the-money put with a near-term expiration. At the same time, we'll buy a put with a further expiration at a strike price further out of the money.
Here's how we could set it up for Netflix stock.
Traders sell an Oct. 18 put with a strike price of 620 and buy a Nov. 15 put with a strike price of 595.
As of this morning, the Oct. 18 put traded around 7.80 and the Nov. 15 put trade around 8.20. Even though the long put is further out-of-the-money, you're paying up for more time.
That makes the trade a debit with a net cost of 40 cents. Since each contract is 100 shares, that makes the cost per contract $40.
Profits And Losses
If the stock continues higher, the most the trade can lose is the $40 paid for the spread. There is more risk if Netflix stock falls.
The maximum risk on the downside is at $2,540. This is calculated by taking the difference in the spread (25) multiplied by 100 and adding in the cost of the trade (40). A drop in Netflix stock below 500 on the Oct. 18 expiration would trigger that maximum loss.
The trade has a nice profit zone between 600 and 700 with a maximum potential gain of around $1,600. A close right at 620 on Oct. 18 produces the maximum profit but the exact amount can vary as the stock starts to move. In other words, if Netflix stock can hold its 200-day line, the trade should come out OK.
Managing The Trade
Aiming for a return of around 10% to 15% makes sense, and I would set a similar stop loss.
The worst-case scenario is a sharp drop in NFLX stock early in the trade. For this reason, if the stock drops below 645 in the first few weeks, I would also consider closing the trade early to minimize losses.
The initial trade set up has a delta of 2, meaning the position is roughly equivalent to owning two shares of NFLX stock. Note that this delta number can change significantly as the stock starts to move.
Also keep in mind that Netflix is due to report earnings on Oct. 17.
According to IBD Stock Checkup, Netflix stock ranks No. 1 in its group and has a stellar Composite Rating of 98, an EPS Rating of 98 and a Relative Strength Rating of 90.
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 X/Twitter at @OptiontradinIQ
