Options Trade of the Day: A Netflix Vertical Ratio Put Spread

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Shares of Netflix Inc. ( NFLX ) have plunged nearly 3% today, with the stock breaching former round-number support at the $180 level. The stock has been on fire this year, surging more than 233% since the beginning of 2010. However, the equity's addition to the S&P 500 Index (SPX) and the Nasdaq-100 Index (NDX) , as well as a recent tongue-lashing from Time Warner Corp. ( TWX ) CEO Jeff Bewkes, may have sparked a round of profit-taking from NFLX bulls. Not surprisingly, options traders have ramped up their efforts today by more than doubling the stock's average daily put volume.

Overall, more than 35,000 NFLX puts have changed hands, with options traders centering heavily on the December 180 strike. While digging through NFLX's put volume, I ran across a block of 100 contracts at the January 2011 175 strike, which traded on the Chicago Board Options Exchange ( CBOE ) for the ask price of $10.53, or $1,053 per contact. I found the other leg of this spread on the popular January 2011 165 put, where 200 contracts traded for the bid price of $6.43, or $643 per contract. Given this data, we could be looking at the initiation of a vertical ratio put spread, or a credit spread , on Netflix Inc.

NFLX option volume details


The Anatomy of a Netflix Inc. Vertical Ratio Put Spread

Breaking down this vertical ratio spread, the trader would have purchased 100 January 2011 175 puts for a total outlay of $105,300 -- (10.53 * 100) * 100 = $105,300. Meanwhile, the trader also sold 200 January 2011 165 puts for a credit of $128,600 -- (6.43 * 100) * 200 = $128,600. Combining these two legs results in a net credit of $23,300 -- $105,300 - $128,600 = $23,300.

NFLX vertical ratio put spread details

The maximum profit on this vertical ratio put spread is achieved when the underlying stock falls to the sold strike, which would be the 165 level in this case. However, since twice as many January 2011 165 puts were sold, this spread position will begin to lose money after NFLX moves below $165 per share. Once NFLX breaches this region, only half of the 200 sold January 2011 165 puts are hedged by the 100 purchased January 2011 175 puts. As such, the trader will begin to lose money on the unhedged portion of those sold January 2011 165 puts as NFLX moves lower. Below is a chart for a rough visual representation of the trade's profit/loss scenario:

Correction: The chart below was updated to accurately reflect the profit/loss levels for this strategy.

NFLX vertical ratio put spread profit/loss chart

Implied Volatility

While ordinary vertical put spreads are not greatly impacted by rising implied volatility, a spike in implieds could be detrimental to a ratio spread. Since the trader has sold more contracts than he has purchased, rising implied volatility on these options would negatively impact the position, as it would make it more costly to repurchase these contracts should the trader need to do so. At the time of the trade, implieds for the January 2011 165 puts arrived at 53.15%, while the implied volatility for the January 2011 175 put rested at 52.24%. NFLX's one-month historical volatility arrived at 52.60% as of the close of trading on Monday.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Options

Referenced Stocks: CBOE , NFLX , TWX

Schaeffer's Investment Research

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