Arcángel de Jesús Montoya
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Arcángel de Jesús Montoya in Alexander Valtsev,

Your One-Week Options Trade In Netflix

In my last two articles, I actively promoted the iron condor options strategy. You can read them here and here. What you should have noticed about those trade ideas, if you read closely, is that they offered mediocre risk-return opportunities. Let us face it: risking more money to get less or the same in profits is not particularly sexy. Even if there is not ambiguity about returns and you get a credit balance as a result of the trade. Well, the good news is that iron condors or butterflies do not always have this sort of risk-return profile. In fact, if your trades are short-term (one- two-week positions), time value starts playing a huge role in the success of your trade. This is especially true with the reverse iron condor strategy when the investors sells at-the-money options and buys out-of-money options to hedge the downside. The fact is that at-the-money options decay faster on short-term time periods, as opposed to out-of-money options, which a more linear decay over their lifetime. This can be illustrated in a neat diagram:


The difference in time decay rates is exactly the reason why short-term reverse iron condors are more attractive than their longer duration counterparts. If you are an iron condor buyer (you buy ATM options and sell OTMs), you are better off buying more time, even though this means more premium for time value (i.e. more costly to you). 

Let us get back to the main topic of this article. I have found an interesting trade in Netflix's (NFLX) options expiring in one week - on April 22, 2016. My idea is to sell expensive at-the-money options (calls and puts) and hedge myself with out-of-money options (calls and puts) in order to lock in a favorable risk-return ratio:


The maximum return here is $788 per one contract (equivalent to 100 shares), while the maximum risk is limited to $312 per one contract. This results in a risk-return ratio of over 2.5x: that is, for every one dollar of risk carried, the investor is accepting $2.50 of expected return. I find this very attractive. At the same time, remember that $788 is immediately credited into your account. I like this type of trades because I like to get cash upfront. In addition, time decay works in your favor, as evident in the above chart. Finally, in addition for the counterparty to make money off you, the underlying has to move 7% over the next five trading days. This may sound a lot over a five-day period but keep in mind that Netflix is reporting Q1 2016 earnings on Monday evening (after market close) which is exactly why the straddle is so expensive (~10% of the stock's market price):

(Source: TD Waterhouse)

If you think volatility will pick up on Tuesday and thereon, buy the straddle on Monday. Typically, however, volatility drops after earnings, so all you can hope about as a buyer is that the underlying will make a swift move in either direction. This happens less often than people tend to think but I do not want to give any forecast on this matter. I simply find the trade idea very attractive from both the risk-return and the time commitment perspectives. 

Please let me know what you think of this trade and offer your own alternatives, if something comes up to your minds.