In light of today’s big drop with Netflix I thought I should do an update on the company since I have heard from many readers who have jumped in on the short game with this stock.

Yesterday bought May 75 put options on NFLX @ 135 Today sold the puts @ 105 after NFLX is down 13 pts. That’s enough for me. ~ astrology trader subscriber

I have written a couple articles here about the astrology transits that would continue to cause difficulty for the company.  In my last article on February 17, 2011 I detailed what I felt would be more selling pressure on the  company’s stock through April.   Being confident about the direction with a company’s stock is one thing, but how to trade it is another.  These trades are risky and even when you are right you can lose money.

Shorting a stock has risk and many traders prefer to use options to reduce that risk.  There are some important considerations to make before establishing an options trade even when you are certain of the outcome, Here’s an example of how a put option on Netflix can lose money even when you are right about the direction of the trade.

We asked the resident options expert Chris Ebert on Zentrader how one could lose money on a put when the stock gapped down so much. Here is a very detailed response about a scenario that I didn’t even know was possible. This is very important information for those who are new and starting to learn option trading and the risks involved.

The behavior of the NFLX options is due to the super-efficiency of the options market. I can understand the subscriber’s frustration because I had similar experiences when I began trading options. Who wants to be right about a trade and lose money?

I cover similar option trading scenarios in my book “Show Me Your Options!”. In this case, NFLX analysts were predicting a loss of $0.27 per share so implied volatility was being driven very high on Monday. The increase in volatility was due to the likelihood that the stock would plummet after-hours when the earnings were announced. So put options became much more expensive than normal on Monday.

I would suggest that the subscriber should consider that the $75 May puts began trading Monday near $0.75 and gradually increased in price, briefly reaching $1.50 in the afternoon, as fear about the earnings announcement was building (this was occurring even as the share price remained nearly flat at $102). After the earnings were announced, fear immediately evaporated, so much so that even though NFLX shares fell by about 18%, the value of the puts actually decreased.

The reason that the put premium decreased is because there is a much smaller chance that they will be in-the-money at expiration than there was yesterday. After all, the company beat almost all of the analysts estimates, so some stock traders would be inclined to see that as a buying opportunity. The only reason for today’s 18% decline was that speculators who were hoping for a big win after earnings are now dumping their shares. In order for the $75 put strike to be hit, the share price would need an additional 14% decline, and there is currently no catalyst that would cause that before mid-May. Most likely the price has now found support, at least temporarily.

I hope this helps. I have personally found Karen’s advice to be very helpful, and it would be a shame if he were to miss out on that in the future because of a misunderstanding about the options market.