Monday, September 22, 2014

* Netflix (NFLX) - Option Market Was Dead Wrong & Has Been for Two-Years

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NFLX is trading $440.66, down 3.7% with IV30™ up 22.3%. The Symbol Summary is included below.

Provided by Livevol

I have written about NFLX extensively over the last couple of years with the tone staying relatively consistent: The option market has been mis-pricing risk and has created one of the greatest trading opportunities ever. Today is an example of the same.

Before we get into the option stuff, let's look at a great opening chart: This is NFLX stock price (in orange) vs. Earnings (in light blue).  How's that for a correlation (this does not necessarily imply causality)?

I have too many prior articles to post here, but here are the most relevant to this risk pricing phenomenon.

NFLX - The Volatility Phenomenon is Old, Is it Still Relevant?

NFLX - All-time Highs & One of the Greatest Trading Opportunities Ever

How the Option Market is Totally Wrong; Proof that Market Volatility Has Lost Its Mind

NFLX - The Option Market is Dead Wrong... Again

NFLX - Unprecedented Low Risk?... How Many Times Will the Option Market Prove Wrong?

NFLX - "Less Risk Now than In the Last Two-Years." Do You Agree? I'm Not Sure I Do.

You get the point...

Let's turn to a five-year stock chart and we can see how this risk phenomenon developed.

Provided by Yahoo! Finance

NFLX stock, more than most companies, moves in massive trends  The green arrows follow the bull trends, which are extensive in size and time,  The red arrows follow the bear trends, which are as substantial in size, but occur (start to finish) much faster.

These prolonged periods of up or down moves have created an "historical volatility" (HV) that appears low.  But, if we were to take a magnifying class to those extended periods of "mono-directional" movement, we would see bumps... rather large ones.  So in fact what we have with NFLX stock (in the past), is massively large moves in one direction together with rather loud bumps in between.

So... what's low risk about that?... So far, nothing,  The stock has moved more than the option market has priced.  In fact, on the close last Friday, the at-the-money (ATM) straddle for the Sep 26 weekly options was priced to ~$9.90. The image is included below.

As we will see by the end of this article, that straddle, in one day, is now worth $17.50, or ~75% more.  That's called... "risk was priced to low."

Let's turn to the IV30™ chart in isolation, below.

Provided by Livevol

The implied volatility is the forward looking risk in the equity price as reflected by the option market (IV30™ looks forward exactly 30 calendar days).

In English, the red curve is the risk in future stock price movement. We can see a hypnotically consistent trend in the risk -- it's going lower.  In fact, it has essentially been cut in half over two-years.  All the while NFLX stock has seen some rather large moves (read any of those old titles above).

The Skew Tab snap (below) illustrates the vols by strike.

Provided by Livevol

NFLX skew shows a parabolic shape. In English, the out-of-the-money (OTM) calls and puts are priced to higher volatility than the ATM options.  The option market reflects two-tailed risk.  But, don't confuse this with the larger picture (that IV30 chart) which demonstrates rather explicitly that risk overall is shrinking per the option market.

To read more about skew, what is and why it exists you can click the title below:
Understanding Option Skew -- What it is and Why it Exists.

Finally, the Options Tab is included below.

Provided by Livevol

If we look at the Sep 26 (weekly) option, and the $457/7 strike, we can see it's now worth ~$17.50 (was priced at ~$9.90 on Friday).

As of today, using the at-the-money (ATM) straddle we can see that the option market reflects a price range of [$429, $451] by the end of trading on Sep 26th.

Looking a bit further than the immediate-term, the open market reflects a price range of [$414, $466] by the end of trading on October 17th.

  • If you believe the stock will be outside that range on expiry or any date before then, then you think the volatility is too low.
  • If you believe that range is too wide, and that the stock will definitively be in that range on expiration, then you think volatility is too high.
  • If you're not sure, and can make an argument for either case, then you think volatility is priced just about right.

This is trade analysis, not a recommendation.

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