Netflix: The Toughest Lesson I Ever Learned

For about a year and a half, Netflix (NASDAQ:NFLX) was the go-to stock for momentum players. The stock rallied about 525% from 2010 to July 2011, including more than 70% from January 2011 to its peak near $300 in early July.

The rest, as you know, is history.

What you might not know is something a little less documented — that is, an honest look at one trader’s excursions through the Netflix vertical rally, and its subsequent run into a brick wall.

A rule I have learned to respect is that the force of gravity doesn’t just apply to physics — it also applies to stocks and other risk assets. Google (NASDAQ:GOOG) in 2007 and so many other go-to stocks have taken hard stumbles after being bid up by seemingly every investor under the sun. From a trader’s point of view, it can be very lucrative to catch the “correction” in these stocks once they get rolling because assets almost always correct quicker than it takes them to rally. Momentum funds are quicker than the ticker when it comes to getting out of a momentum investment, causing these downward spirals to spin out of control — if only temporarily so.

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As far as Netflix is concerned, I did trade the long side of the stock for parts of 2010 and even sporadically in early 2011. At some point, though, I started hearing voices in my head telling me that the stock just couldn’t go much higher, which led me to form an opinion.

And even though one of my iron-clad rules is to never let an opinion get in the way of price action, it happened, and it ended up costing me dearly.

I subconsciously started forming this opinion in the spring of 2011 after the stock overcame its weakness in February, which to me was the beginning of the end. As such, once the stock neared the $250 mark, I opened my first short position, betting the stock would see $200 before it would see $300. A month went by, and although the stock kept trading with a weak undertone, eventually it shot above my $250 mark and started to squeeze me.

At that point, my usual routine is to either cut out, or at least reduce the size of the position, because any good trader knows that anything can happen — especially with momentum stocks. Instead, I fell deeper and deeper in love with my opinion that Netflix as a stock, as a company and its business model was unsustainable.

I dug up every single research piece confirming my view, took apart the company balance sheets and extensively researched the industry. Everything confirmed my view that NFLX should fall apart imminently.

Like a crazy-eyed gambler, I doubled down on my position, shorted more stock and sold out of the money calls in the options market. The stock continued to climb and eventually went vertical in early July, causing me severe losses and a good helping of pain.

I could have avoided three months of stress and agony by sticking to a stop-loss level that I had originally planted near $260, which would have kept my losses to less than 4%. But trading is 90% between the ears, and all the rules in the world won’t help if we can’t stick to them.

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I finally caved and closed/bought back most of my short positions in the stock on July 7, 2011, which was the beginning of a very visual seven-day top-building process. On the chart to the right, note the several doji (indecision) candles followed by a long, red, engulfing bar.

It was a picture-perfect sell signal.

But to me, the mental damage had been done, and I didn’t want to hear anything about Netflix again for two weeks. It wasn’t until NFLX was 15% off its highs that I returned to sanity and allowed myself to again see the price action for what it was.

During the next few months — after taking some time off — my analysis came true and the stock literally fell apart. I played the short side, mostly by selling far-out-of-the-money calls for high premiums, as Netflixoholics still spewed hope aplenty. By the end of the year, I had not only made back all of my losses, but ended up with handsome profits.

Were those profits worth the three-month-long agony, stress, self-doubt and accumulation of losses? No.

When trading, we must separate our analysis from price action, as fundamentals and the stock price can remain imbalanced for longer than we can stay in a position. I let an opinion blind me on the risk in my trading position, and it hurt.

It was a tough lesson to learn, but one that was essential for me to experience before I could enjoy steady trading success.

Serge Berger is the head trader and investment strategist for The Steady Trader. Sign up for his free weekly newsletter.

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