Netflix, Inc. (NASDAQ:NFLX) reported earnings on July 17, with the news that the company added 5.2 million new subscribers, handily beating expectations of 3.23 million. This news sent NFLX stock soaring, with shares gaining more than 18% before finally stalling out at the $191 level.
But there were a few things that I think Wall Street will look back at less than fondly as they digest the report. Revenues, for instance, only beat by a small amount, at $2.79 billion versus expectations of $2.76 billion. Earnings actually missed by a penny at 15 cents versus analyst consensus of 16 cents.
If history is any past guide, I expect the recent rally in NFLX stock to consolidate at current prices.
Netflix’s valuation is certainly stretched. As our own InvestorPlace contributor Vince Martin so accurately assessed pre-earnings, valuations always seem to be stretched here. He was spot-on with his analysis that subscriber growth will be the metric analysts will scrutinize most closely.
At some point, however, valuations must matter.
In the case of Netflix stock, price-to-sales is now well above 8, which has proven a sign of extreme overbought levels in the past. This also has proven to be a headwind for further price appreciation in Netflix shares.
NFLX also is getting extremely overbought on a technical basis, with the 14-day Relative Strength Index now above a 75 reading. The last time Netflix was this overbought, shares faced a significant intermediate-term top.
Interesting to note is that the previous overbought reading also occurred on a post-earnings gap higher.
Netflix also failed to break out to new highs yesterday after opening higher, with shares of NFLX stock ultimately closing lower on the day. This type of reversal pattern, especially following such a strong rally, many times is a sign the buyers have become exhausted.
The options market also is showing signs of extreme bullishness, with out-of-the-money calls now trading at a higher level of implied volatility versus out-of-the-money puts. Normally this condition is reversed with puts carrying a higher price tag than calls. This is also a reliable contrarian sign sign that the upside euphoria may be getting overdone.
So to take advantage of a stock that is getting over valued and overbought and looking tired from a technical standpoint, a bearish short call spread trade that captures some of that rich call premium is the way to go.
How to Trade NFLX Stock
Buy Aug $202.50 calls and sell Aug $200 calls for a 45-cent net credit.
Maximum gain on the trade is $45 per spread, with maximum risk of $205 per spread. Return on risk is 21.95%. The short $200 strike price provides a 6.43% upside cushion to the $187.91 closing price of NFLX stock.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at deltaderivatives@gmail.com.
