Netflix is bouncing back after a minor pullback and broke back above the 50-day moving average on Wednesday.
Netflix is due to report earnings after the closing bell on Oct. 21. Volatility skew is high due to the pending earnings announcement, with short-term options showing higher implied volatility than long-term options.
Creating A Diagonal Put Spread
One way to take advantage of this skew is via a diagonal put spread. It's an advanced strategy because it utilizes options over different expiration periods and different strike prices. Let's look at an example:
Traders could sell an Oct. 24 put with a strike price of 1,090 and buy an Oct. 31 put with a strike price of 1,080.
As of Wednesday's close, the Oct. 24 put could be sold for around 9.90 and the Oct. 31 put could be bought for 10.95.
The trade would result in a net debit of around 1.05, which means there is very little risk on the upside. The worst thing that can happen is the puts expire worthless and the trader loses the 105 in premium paid.
Meanwhile, the risk on the trade is on the downside with a potential maximum loss of 1,105. This is calculated by taking the difference in the spread (10) multiplied by 100 and adding the premium paid (105).
The maximum potential gain is estimated at around 2,350, which would occur if Netflix closes right at 1,090 on Oct. 24.
The break-even prices are estimated at around 1,030 and 1,240. So, the trade will do well if Netflix stock stays around 1,200 for the next week or so.
Netflix Trade Scenarios
Aiming for a return of around 10%-15% makes sense, and setting a similar stop loss is also prudent move.
The worst-case scenario is a sharp drop in Netflix stock early in the trade. For this reason, if the stock drops below 1,100 in the next week, investors can consider closing the trade early to minimize losses.
The initial trade setup has a delta of 0, meaning the position is directionally neutral. Note that this delta number can change significantly as the stock starts to move.
One of the advantages of the trade is that the put we are selling has higher volatility (51%) than the put we are buying (46%). Just like stocks, when it comes to volatility, we want to buy low and sell high.
For investors, closing before the Oct. 21 earnings date is a good idea to mitigate risk.
Rankings At IBD
Investor's Business Daily gives Netflix stock a Composite Rating of 93 out of a best-possible 99, an Earnings Per Share Rating of 97 and a Relative Strength Rating of 80.
Also, according to IBD Stock Checkup, Netflix ranks first in its industry group.
It's important to 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 due diligence and consult your financial adviser before making any investment decisions.
Gavin McMaster has a masters in applied finance and investment. He specializes in income trading using options, and is conservative in his style. He also believes patience in waiting for the best setups is the key to successful trading. Follow him on X/Twitter at @OptiontradinIQ.
