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I’m considering shorting NFLX and want to know how a Bear Put Spread might help in reducing my risk?

I’m considering shorting NFLX and want to know how a Bear Put Spread might help in reducing my risk?
Asked by
Sam Button categorie-icon time-icon4 months ago

Sheila Olson
Answered time-icon4 months ago

Used correctly a Bear Put Spread will significantly reduce your risk. There is a trade-off though as the strategy will also limit your potential returns.

Before you start thinking you’ve stumbled upon some kind of wonder-trade it’s important to note there are other risks associated with it. The first risk is that any strategy is open to human error and this one is no exception. It relies on the process being clearly understood and effectively executed. There is also the risk that the potential market move that you think is about to happen, just doesn’t occur.

The Bear Put Spread is a strategy that aims to make some profit, but not excessive profits, from downward price action.

Naked Short in NFLX

NFLX is trading at about the $265 level. A naked short in the CFD would expose you to the full extent of any gains (from price falling) but also any losses should price rise. Considering that price touched $385 within the last two months you’d be putting on a position in a relatively volatile instrument and engaging in a fairly aggressive risk return policy.

Source: Interactive Brokers 20181127

Bear Put Spread on NFLX

Confident that your analysis is correct, and that price is due to carry on down to as low as $200, you could design and execute a Bear Put Spread to profit from that move.

It is imperative that you put the trades on in the same instrument. Both trades have to have the same Expiry date. Using live prices as quoted by Interactive Brokers the Puts with Expiry of Feb 15th 2019:

Buy: 100 Put Options with Strike Price 250 – cost: 17.75
Sell: 100 Put Options with Strike Price 200 – revenue: 5.15

The profit you make using this strategy is:
(Revenue from Put sale – Cost from Put buy) + (Higher Strike Price – Market Price of underlier or Lower Strike Price, whichever of these two is the smaller)

The Revenue and Cost are known at the time of the trade, as are the Strikes of the Options you traded. The only remaining variable is market price. Should this reach levels of EUR 237.40 = (250-17.75+5.15 or lower you will make a profit. Profit is capped at EUR 37.4 per option = (237.40-200)

Risk Management

If you have made the wrong call and the price doesn’t head south between trade date and Feb 15th 2019 then your downside on the trade is capped at EUR 12.60 = (5.15-7.75). This being difference between the premium paid and received to put on the trades associated with the strategy. Both Put positions will simply expire worthless as they are out of the money.

If you find you do make the right call in terms of market direction there is still the risk that you made an error when putting the trades on. There are only a certain number of data fields that need to be checked over, but it is important some kind of four-eye check / reconciliation is done.

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