Option Traders Looking for a Floor in Netflix

• stevenplace
• September 20th, 2011

We all know Reed Hastings feels bad, but that’s little consolation to $NFLX investors.

Over the course of 2 months, what was once a stellar, high-flying momentum stock has seen its share price get cut in half, with the brunt of the damage coming over the past three trading days.

As it stands, the easy trade to the long side is over. $NFLX was a great stock and had been on my stupid valuation screener for months, indicating higher prices.

But when momentum breaks, the downtrend can continue much longer than what traders believe. This has to do with recency bias and the belief that positive price momentum will manifest itself again after a brief correction, but a look at past momentum darlings like $CREE, $CY, $FSLR, and many others show how long this kind of condition can persist.

But on the short term, $NFLX could be a tad oversold. And the options market is potentially looking for a short term bottom.

Evidence of this can be seen in the options skew, chart courtesy of LiveVol:

Normally when a stock sees a strong downside move like NFLX has, the out of the money options will have a much higher implied volatility than the at the money options. This is due to the fact that investors fear disaster movements more on a relative basis than mild pullbacks.

The shape of the skew curve would normally be that of an exponential line, in which the rate of change continues to increase. But if we examine the October options, there are inflection points in which the second derivative is negative. In other words, certain OTM options are being sold.

The big $NFLX trade going on right now is the put credit ratio. This is a trade in which a put is bought and then two further out of the money puts are being sold. This kind of trade, done in size, would lead to the current shape of the $NFLX skew.

The question now is whether the option traders will be right this time, or if they will be punished with further downside. I’m leaning towards the former.

New to trading options? Haven’t a clue what this option skew really means? Check out my video course at OptionFu and you will become a better options trader, guaranteed.

Photo of the bungee jumper from syymza.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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