Tim Bovee, Private Trader: NFLX: Keeping hope alive

Update 7/25/2014: NFLX fell below its 10-day price channel on July 24 and confirmed it by closing below the breakout level today.

I've removed NFLX from the Watchlist without having opened a position.

The chart shows that NFLX reversed after peaking on July 2 at $475.87. The Elliott wave analysis clearly shows wave 3 {+2} to have ended on that date. Wave 4 {+2} is underway.

Click on chart to enlarge.

NFLX 2 years 2-day bars

Update July 2, 2014: NFLX closed above the $458 level, which I considered to be the true break above resistance, on July 1 and confirmed it by closing above that level the next day.

Even with the breakout, the chart remains ambiguous. What I've labelled as wave 5 {+3} in my primary count may well be the 2nd -- retracement -- wave of a downward correction of the rise from 2002.

The bearish scenario in my alternate count would mean that NFLX has begun a flat, whose B wave can exceed the prior, pre-correction peak.

If the bullish scenario is correct, then NFLX will push up to significantly higher levels in a 3rd wave. If the bearish, then it will soon reverse.

The magnitude of wave 2 {+2} is not unreasonable. It amounts to a 38.2% Fibonacci retracement of the rise from $52.81 beginning Aug. 3, 2012.

However, wave 2 {+2} in my primary count fails to break down into five waves. It is composed of three waves, which is more consistent with the alternate count of a flat correction.

Given those ambiguities, I'm unwilling to open a bull position in NFLX at this point. I'll keep NFLX on the Watchlist, without a formal target and see how it develops between now and the July 21 earnings announcement.

Click on chart to enlarge.

NFLX 14 years weekly bars (left), 2 years daily bars (right)

Netflix Inc. (NFLX) has been the darling of the changing media landscape since it went public in 2002, challenging the models that govern how film and TV series are both produced and distributed.

But since March NFLX has lost momentum on the markets, as its shares have declined by 35%. Late April saw the beginnings of a fresh upturn, but the chart shows profound ambiguities regarding how the new trend should be interpreted: As a renewal of a tech juggernaut that has reinvented its sector, or as a quixotic effort to keep hope alive.

The Chart

Beginning in early March, NFLX traced a hook to the downside, culminating its rise from July 2012 that multiplied the price nearly nine-fold.

The purpose of framing the chart using Elliott wave analysis is to learn the significance of that hook. Is it a pause in NFLX's upward course? Is it the beginning a correction that will take back part of that massive rise?

The answer to that question in turn determines the significance of the NFLX bull signal produced on Wednesday when the price moved above its 20-day price channel.

Does it signal a fresh uptrend that will eventually exceed the March 6 high of $458?

Is it an upside correction within a bear trend that has already reached a point at which reversals tend to occur, the Fibonacci retracement level of 61.8% ($397.45 on this chart)?

NFLX had its initial public offering in 2002. It is much like kid who got to the movie theater late and missed the first half of the film.

To account for that, I've done two analyses of the charts.

Click on chart to enlarge.

NFLX 12 years weekly bars (left), 90 days hourly bars (right)

The main count, in larger figures, is the more straightforward, looking the NFLX chart as a thing in itself, a new world created on IPO day, May 23, 2002.

The alternate count (smaller figures, prefixed with "Alt:") puts NFLX in the context of the broader market, imposing an analysis of the S&P 500 on the chart and embedding the stock in history.

The count since the present decline began on March 6 suggests that the main count is most likely correct, but it doesn't entirely rule out the alternate count.

The alternate count leaves Alt: 3 {-1} ending April 28 as potentially shorter than both the 1st and 5th waves of the same degree, something that is forbidden by the Elliott wave rules.

The 5th wave, of course, has not yet begun, so far as anyone knows at this point. But, as of this writing the high of the wave Alt: 4 {-1} upside correction is $397.50. The 5th wave to the downside must be shorter than the 3rd wave to met the Elliott requirement, which means it must stop above $316.12.

Wave 3 {-1} ended at $299.50 and 5th waves typically move beyond the end of 3rd waves. There are instances of failed 5th waves that come up short, but they aren't common.

If the alternate count is correct, then NFLX is most likely poised for a downturn very soon. If the main count is correct, then NFLX most likely has more upside potential.

Options are pricing in confidence that 68.2% of trades will fall between $350.58 and $439.74 over the next month, for a potential gain or loss of 11.3%, and between $373.74 and $416.58 over the next week. I've marked those levels on the right-hand chart in blue.

If NFLX were to exceed the May 6 peak in the next month, then it would be an outlier in the expectations priced into options, as would a decline below the beginning of the prsent wave B to the upside.

Odds and Yields

This is the first NFLX bull signal since the March 6 peak.

The rise from August 2012 completed seven bull signals. Only three were successful, but the average yield was an astounding 43.2%. The four unsuccessful signals lost 3.4% on average.

The resulting 39.8% win/lose yield spread does a lot to overcome those odds. NFLX may be more likely to whipsaw than not, but when it gives a good signal, it has historically come through with big profits.

The Company

Netflix provides on-demand streaming of films and TV series over the Internet to customers in the Americas and Europe, and DVD-by-mail services within the United States. In said in 2013 that it had 40 million customers, 33 million of them in the United States.

U.S. streaming accounts for nearly two-thirds of the market capitalization, compared to a fifth for international streaming.

Analysts are less than optimistic about the company's prospects, coming down collectively at a negative 31% enthusiasm index.

The company reports return on equity of 13% with debt amounting to 61% of equity. These figures diverge sharply from my criteria for a growth stock; 20% return on equity with debt blow 10% of equity.

Growth estimates suggest that the stock is overpriced by several multiples and that the "fair" price is $101.04, compared to the market price of $393.62. I've marked the price implied by growth on the left-hand chart in purple.

The earnings yield is a mere 0.68% -- another sign of a high price. The 10-year U.S. Treasury notes, by contrast, have a yield of 2.56%.

The company pays no dividend.

The stock is selling for 148 times earnings, and also at a premium to sales. It takes $4.73 in shares to control a dollar in sales.

Earnings were sharply depressed in 2012 and the 1st quarter of 2013. The last four quarters have sen a recovery, with steadily rising earnings that have yet to regain the peak earnings in the 2nd and 3rd quarters of 2011. Netflix has had but one losing quarter, the 1st quarter of 2012.

The company's earnings have surprised to the downside only once in the last three years, in the 1st quarter of 2013. The other announcements surprised to the upside.

Institutions own 84% of shares.

Netflix next publishes earnings on July 21.

Liquidity and Volatility

NFLX on average trades 3.4 million shares a day and has a wide selection of option strike prices spaced $5 apart. The front-month at-the-money bid/ask spread on calls is 1.5%, compared to 0.4% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 39%, compared to 12% for the S&P 500 index, and has been on the decline from 69% on April 10.

NFLX volatility stands at the 19th percentile of the year range, suggesting that the most successful positions would be structured as long options spreads bought with a debit and expiring in August or September.

Contracts are trading actively today, with both calls and puts running at more than double their five-day average volume.

Decision for My Account

I'm quite wary of NFLX because of the oddities of the near-term chart. My Spidey sense tells me that the main count is correct and a decline is coming soon. The fact that a stock is overpriced has less relevance for a shorter-term trade like this one, but still, a triple mark-up? Please!

An earnings yield of 0.68% means that there is so much optimism priced into this stock that the trader would have to believe that Santa Claus, the Tooth Fairy and Tinker Bell were all collaborating to keep hope alive.

The 55-day price channel's upper boundary stands at $458, the level of the March 6 high. A move beyond that point, about 15% above today's high, would confirm that the uptrend was back in force.

I'm not trading NFLX today. I shall add it to my Watchlist for consideration if it breaks above $458.

References

My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading.

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my shorter-term trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.