Following Netflix’s late October 2011 earnings disappointment, shares cemented the stock’s out-of-favor position with growth traders. But with NFLX’s rapid drop in excess of 70% from its highs and the company still the dominant player in the to-your-doorstep or streaming video market, what are your thoughts on buying a LEAPS call as a way to position for some upside?
It’s not my place to give recommendations on a particular stock. What I can say is that despite your prognosis of shares, a long call strategy with a long-term contract needs to assess liquidity and implied volatility.
Separately or combined, both factors can have a substantial negative impact on profitability.
But the good news? Liquidity in NFLX LEAPs is reasonable with bid/ask spreads for individual contracts in the 2% to 3% range. The bad news is with most of the surrounding money options priced in the high teens into the 20s, the spread means there’s slippage risk on entering and exiting.
As of this writing in the first half of December and shares bid into the mid-70s on takeover “Amazon-for-Netflix” chatter, premiums in the surrounding money calls are priced around 25% to 30% of the underlying share price with implieds near 70%. The pricing is unexceptional. However, on a dollar basis for a wasting asset such as a long call position, which could be worthless in about a year, the situation is reason enough to consider spreading the risk with a sale such as with a calendar, horizontal, or vertical spread.
If a takeover were to occur, the “unexceptional” pricing of a long call in NFLX needs to weigh the impact of a deal and what that contract (or aforementioned spreads) might look like should a buyout be announced. Even if a premium deal is agreed upon, a near-the-money, let alone an out-of-the money call, could see its value disintegrate to zero due to an implied volatility implosion or the option’s intrinsic worth adding up to less than the extrinsic value paid for the contract. And with that kind of storyline, there’s no room for sequels, for better or worse.