Icahn revealed his Netflix bet on Halloween.

As we have all seen over the last week-plus, Netflix has enjoyed an incredible rally. First, rumors flew that Microsoft might be interested in acquiring the business, only to be followed a few days later by the news that Carl Icahn has accumulated a position that could result in him holding 9.98% of the company’s shares according to an SEC filing .

We see these types of plays fairly often where an investor or institution accumulates the stock of a company with an eye toward an acquisition or to shake things up and steer the business in a different direction. In my opinion this one is so much more interesting because, as my friend Steve Schaefer reported in his Oct. 31 column. Mr. Icahn accumulated his position primarily by purchasing call options.

As a quick review for those of you newer to options, buying a call gives you the right, but not the obligatio,n to purchase a stock, at a specific price, over a specific period of time. Mr. Icahn purchased enough calls that by exercising his right to buy the stock he could take a large stake in Netflix. if he exercised his right to buy stock, would give him a large interest in the stock.

At first glance the strategy seems unconventional, but it makes sense and it actually makes me very happy to see this play out as it reinforces something that I have been writing about since my first column here at Forbes. always define your risk. It makes sense to always know the worst-case scenario, for everyone from legendary investors with a few billion dollars at work to those just starting out.

Let’s take a look at the long call strategy and what this really means. Mr. Icahn accumulated call options in order to achieve this position. The major advantage to this strategy, as opposed to going long the stock outright, is that all he can lose is the amount paid for these calls and as you can see all the examples below are much cheaper than purchasing a stock that is trading at $66. If it were to go to zero it would be a significant amount of capital to lose, and even if it were to lose say 30-40%, this is a significant amount of capital to risk. If someone wants to accumulate a stock position the next step is to determine what strike to purchase. There is an old saying among options traders and that is, buy value and sell junk. The reason I mention that is because the next logical question for most folks is what options did he buy? It does not actually matter which one he did purchase, what is more important is what will you do if you want to buy calls in order to buy stock.

Click to enlarge. TD Ameritrade’s thinkorswim platform. For illustration purposes only.

In the example above, taken from Oct 22, 2012, you can see I have shaded two particular strikes. Those strikes are the November $60 strike call and the December $62.5 call. As we look at what can help us in our own individual trading, that is ultimately what matters.

If you want to buy some calls with the goal of helping you take control of the stock, these are two options that seem to make sense. There are a few reasons for this, starting with probabilities. As you can see I have delta reflected on this layout. Delta is a measure of an option’s sensitivity to changes in the price of the underlying asset. However, I have also found that the delta of an option can be used as a thumbnail probability of the option being in the money on expiration day. The November 60 has a 71 delta, and the December 62.5 call has a 63 delta. This gives us a good idea that the options we are buying will give us a roughly 65-70% probability of being in the money on expiration day (in other words we have a 65-70% chance of taking control of the stock, with a 30-35% chance the option expires worthless.)

This is just a guide but I have picked these options for a reason. The first one is although volatility is elevated in Netflix — and thus premiums are higher — the ratio of intrinsic to extrinsic value is reasonable. Also you will find that these options overall tend to not be as expensive in real dollar terms. I would remind you that if you want to be more aggressive in making sure you get the stock, you may want to go higher in delta, but it will cost more in terms of real dollars. The other concern would be the time frame. If your goal is to start accumulating the stock, the farther you go out, the greater the stock can move around. This puts your initial theory of wanting to accumulate the stock at risk.

Although most of us are not in the situation of investing hundreds of millions or billions of dollars, we can put our lessons on the same plane. If you consider the overall theme that is being stressed by this investment, it is that you need to define your risk. Mr. Icahn’s trade is big, but even with all of his money he wants to know the worst case scenario going in to the investment. It is amazing how often so many retail traders do not do this. Although the real dollars may be significantly less, the value to the investor of the dollars is no less. It is a great lesson to take forward. Through disciplined trading and a good system, hopefully I will be writing about your trades one day.

Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Options .

Commentary and examples provided for educational purposes only. Should not be considered a recommendation for any specific security or strategy.

Supporting documentation for any claims, comparison, statistics, or other technical data will be supplied upon request.

Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring.