Netflix is showing strong ratings and recently gapped up on its last earnings report. If we of the mindset that Netflix stock might pause a bit here, we can setup a trade that will maximize our profit if we are right and minimize the damage if we are wrong.
In the same way we looked at a butterfly trade with Arista Networks, we'll use a similar concept. But by making some changes in the distance between our strikes, we'll create a broken-wing butterfly with a different risk profile.
Setting Up The Broken-Wing Butterfly
Netflix comes in with superior ratings according to the IBD Stock Checkup. It's ranked No. 1 in its group with a best possible Composite Rating of 99, an EPS Rating of 98 and a Relative Strength Rating of 91.
For this broken-wing butterfly spread we'll use puts since the short strikes will be slightly below the current price. Like the butterfly trade, we'll double the option contracts at our short strikes with long puts on either side. However, rather than keeping the long strikes an equal distance from the short strike, we'll leave a larger gap on one side.
The results is less risk on one side and more risk on the other.
Here's how we can setup the trade for a Netflix broken-wing butterfly:
- Buy 1 Nov. 15 put at a strike of 710 @ 5.00.
- Sell 2 Nov. 15 puts at a strike of 740 @ 12.25.
- Buy 1 Nov. 15 put at a strike of 760 @ 21.10.
Notice that the upper strike put is 20 points away from the middle put and the lower put is 30 points away. That changes the risk profile and makes the maximum loss different on the downside than on the upside.
Profit And Loss For Netflix Stock Option
This broken wing butterfly trade will result in a net debit of $160, which is also the maximum loss if the stock finishes above 760.
The worst that can happen if Netflix shoots up from here is that all the puts expire worthless leaving the trader with a $160 loss.
Is Netflix Stock A Buy Right Now? Here's What The Chart And Story Says.
On the downside, the maximum loss is much higher at $1,160. That occurs if Netflix falls all the way below 710 by expiration. To calculate the maximum loss on the downside, take the difference in the widths (10) multiplied by 100, plus the premium paid, or 10 x 100 + 160 = $1,160.
Where do we make the biggest gain? Like the regular butterfly, that occurs if Netflix finishes right at 740 at expiration. The maximum gain can be calculated as 20 x 100 – 160 = $1,840.
Managing Risk
The ideal scenario for the trade is that NFLX stock stays relatively flat and finishes somewhere between 720 and 755. Basically, if we stay on the north side of the earnings gap, the trade will work well. If Netflix goes below its 50-day line, it will hit the maximum loss.
The trade starts with delta of 3, so has a slight bullish bias to start, but that will flip to a negative delta closer to expiry if the stock is still above 760.
In terms of risk management, I would set a stop loss of 20% of the capital at risk, or if NFLX broke below 720.
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
