Shorting Netflix

| February 1, 2012 | 0 Comments

Last Friday, I got a call from a friend who loves to gamble.  As soon as I answered the phone, the tone of his voice told me he’d gambled and lost.

I couldn’t resist finding out what happened.  I don’t know if it was morbid curiosity or what, but I offered to meet him for a beer that evening.

I knew this was going to be good.  But what he told me blew my mind.  And I have to tell you so you never make the same mistake.

Amazingly, this isn’t the first time something like this has happened to him.  He told me about three other times when he’d been so certain about a trade that he put every dime he had into it.

There was a biotech company his cousin worked for.  They were about to release a miracle weight loss pill… But the drug never was approved and the stock plummeted.

Then there was the triple leveraged bearish financial exchange traded fund.  He bought it on margin to juice up the leverage to hedge fund-esque levels.  But financial stocks surged higher for a week and wiped out his entire investment.

And don’t forget about the ‘can’t miss’ for-profit-education stock on the verge of “going gangbusters”.  But the company ran afoul of the Department of Education for their recruiting practices and the stock lost 70% of its value overnight.

And now he’d lost big again shorting NFLX.

Here’s the deal…

My friend lost $30,000 shorting Netflix (NFLX) over the last week.

He shorted the stock at $97 on Monday.  NFLX drifted lower over the next few days.  It reached a low of around $92.  He could have captured a $3,500 profit on the trade at that point.

But he was certain the company was going to report more bad news when they announced fourth quarter earnings on Thursday.  So he held onto his short position in NFLX.

Unfortunately for him, he wasn’t the only one who thought NFLX was going to have a lousy fourth quarter.  In fact, short interest in Netflix went up more than two million shares between December 30th and January 13th.

The open short interest skyrocketed to 11.4 million shares.  That’s more than 20% of all of the outstanding NFLX shares sold short one time.  At the time, NFLX was the fifth most shorted stock in the S&P 500.

Obviously, shorting NFLX had become a very crowded trade.

Then the unthinkable happened… NFLX reported better than expected 4th quarter results.  And the short squeeze was on…

Investors who were short NFLX before the earnings release scrambled to buy back the stock.  By the time the stock market closed on Friday, NFLX had surged to more than $123.  He lost $30,000.  And he was certain his broker was going to cover the trade on Monday if he couldn’t raise the money to meet the margin call over the weekend.

Look, $30,000 may not be much if you’re investing hundreds of thousands or millions of dollars.  But his entire investing account was $50,000.  And he’d put every single penny at risk shorting NFLX.

Obviously, I felt bad for him.  And the worst part is he has a valid argument about NFLX.  The company has some big fundamental issues. And I wouldn’t be surprised to see the stock trade lower over the weeks ahead.

He asked me where he’d gone wrong.  He couldn’t understand how he could be so wrong on the trade if he’s correct about the company’s fundamentals.

I didn’t pull any punches…

First off, I didn’t like the trade for a number reasons.  Most importantly, I don’t like crowded trades… especially when I’m shorting a stock.

Simply put, if the short interest is too high, there’s a good chance of a short squeeze like the one we saw in NFLX last week.

So, make sure you check a source like FactSet Research to make sure the open short interest isn’t above 10%.

What’s more, never put your entire account at risk on a single trade. Especially if you think it’s a sure thing!

Learn from my friend’s mistakes.  There’s no such thing as a sure thing when you’re investing.  And always keep your positions properly sized.  If you can follow those two simple rules, you’ll be a step ahead of most amateur investors.

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Category: Stocks

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

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