A Netflix butterfly spread

July 21, 2016 09:00 AM

Netflix Inc. (NFLX) is one of the FANG stocks, which are all relatively new and have a history of volatility and plenty of liquidity in both the underlying and options. 

NFLX has had some big moves during the last year. On July 14, 2015, NFLX had a 7:1 stock split. On Dec. 7, 2015, NFLX traded as high as $133.27. On Feb. 5, 2016, NFLX traded as low as $85.74. By Apr. 15, it rallied back to $111.85. Less than a month later, on May 12, NFLX dropped to $85.74. It bounced back to $103.50 on May 27. On June 7 NFLX closed at $99.89.

If you are bullish in the near term you could look to buy August calls. As of June 8, August 105 calls could be bought at $5.20. The maximum loss is $520 on one contract at $105 or lower. The upside breakeven point (UBEP) is $110.20. Profit is unlimited, but the volatile nature of the stock requires protection. You can reduce your maximum loss by selling the August 110 calls at 3.50. Your net debit has been dramatically reduced to 1.70. Your UBEP has been lowered to $106.70. By selling the 110 calls you have limited your profit, however. Any move above 110 will result in losses against any gains in your 105 calls. The maximum value of the spread is 5.00 so the maximum possible profit is 3.30 for a 2 to 1 risk/reward. 

You can further hedge your position by selling a higher strike vertical spread against the August 105-110 call spread.  You can sell the August 110-115 call spread at 1.15. The maximum profit is 1.15 at 110 or lower. 
The maximum value of the spread is 5.00 so the maximum possible loss is 3.85. When you combine the 105-110 bull spread with the 110-115 bear spread you have lowered the net debit to 0.55 and created a butterfly. Your maximum possible loss with the butterfly spread is now a third of the loss with the straight vertical bull spread. This maximum loss occurs at 105 or lower and 115 or higher. At 105 or lower, both vertical spreads are worthless so they cancel each other out and you are left with the 0.55 debit plus execution costs. At 115 or higher, both vertical spreads max out at 5.00 so they cancel each other out and you are left with the 0.55 debit plus execution. You max out your profit at 110 when your bull spread begins to attain its maximum value while your bear spread begins to attain its minimum value. Your profit range is between $114.45 and $105.55. While you only have a maximum loss of 0.55 you have a relatively small area of profitability and only achieve max profit at $110 on the dot. This range can be expanded along the chances of achieving maximum profit.  

One way to increase your zone of profitability and profit from a more bullish outlook is to sell a vertical spread that has higher strike prices. Instead of selling the August 110-115 call spread, you can sell the August 115-120 call spread against your August 105-110 bull spread, creating a gap butterfly spread. Your credit for this spread would be 0.35 lower at 0.80. Your net debit would rise from 0.55 to 0.90.  Your downside breakeven would also rise to $105.90. Your UBEP, however, would now be $119.10 instead of $114.45. In the first example of the 105-110-115 butterfly, your max profit is at one price, $110 (see “Gap fly”). In the second example your max profit, which would be 4.10 (better than a 4 to 1 risk/reward), is spread out between 110 and 115. For a stock that moves around as much as NFLX does that might be the better alternative. You don’t have to establish the position all at the same time.  If you’re bullish you can buy the 105-110 call spread and sell the 115-120 at a higher price at a later time. If NFLX heads south then you can sell out the 115-120 at a slightly lower price.

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.