Microsoft (MSFT) – Small Window?

by riskreversal October 20, 2016 11:34 am • Trade Ideas

Three weeks ago we made the case that before this market rally is all said and done, there is a very strong likelihood that shares of Microsoft (MSFT) will make a new all time high:

The next identifiable catalyst for MSFT will be its fiscal Q1 results on October 2oth.   When the company reported their Q4 back in July that beat expectations, they might have pulled forward some demand in an attempt to close out their fiscal year, and given the billings commentary from (CRM) a month ago, it might suggest some softness in enterprise software spending. But given some new focus on what should be high growth initiatives, investors may look beyond current headwinds.

Make no mistake, just as the stock is approaching historical highs in terms of price, it is doing so in valuation, trading nearly 20x expected fiscal 2017 eps of $2.90, only growing 4% yoy on 2% sales growth.  Oh and regular readers also know that we are not fans of MSFT’s $26 billion bid for LinkedIn (MorningWord 6/13/16: $MSFT gets $LNKD).

So the stock is expensive to the market and its own history, recently made the largest and fairly questionable deal of its existence, trades very near an all time high, and the broad market could be in for some volatility. Oh, and current trends in tech suggest that m&a might be getting a little frothy, like a game of musical chairs that feels less than bullish. But, I am not sure how the stock does not make a new all time highs in a market that remains bid through the election and a passive Federal Reserve (until mid Dec), and I’m certain will do so if Q1 results and forward guidance are even slightly better than expected.

Well that catalyst is upon us, with fiscal Q1 results due tonight after the close.  The implied move in the options market is about 4.5% in either direction, below the 4 qtr average one day post earnings move of 7%. With the stock at $57, the Oct 21st weekly 57 straddle (the call premium + the put premium) is offered at about $2.60, if you bought that and thus the implied earnings move you would need a rally above $59.60 or a decline below $54.60 to make money, which seems fair.

In the original post from Sept 30th we detailed a bullish strategy for those…

inclined to play for an earnings gap to new highs, or are long, worried about the issues detailed above, then you definitely want to define your risk.  I would merely target near the money calls in October expiration which will catch the earnings event:

MSFT ($57.50) Buy Oct 57.50 calls for $1.45

Break-Even on Oct expiration:

Profits: above $58.95

Losses: up to 1.45 between 57.50 and 58.95, with max loss below $57.50.

Rationale: risking 2.5% of the stock price, with a break-even up 2.5% defines risk near the highs in the stock in case of a market pullback while being there if the market and MSFT make new highs under favorable conditions into an earnings event the day before October expiration.

On last Friday’s Options Action on CNBC, Dan updated this view, highlighting the fact that the stock was in the exact spot of where we first detailed the strategy, and that while the calls had not lost too much of their value over the two week period, the trade with days to earnings has become very binary due to the lack of movement and the inability to spread and reduce the premium at risk and a roll out to Dec or Jan was the correct call:

So where are we now? The original post had little to do with MSFT’s PC exposure, and all to do with their push into emerging technologies and continued growth with their cloud offerings and public cloud. Intel’s (INTC) Q4 guidance given Tuesday suggest that PCs had their short lived push with inventory restocking that caused a greater than seasonal bump in Q3, but we are back to sucking.

As Dan stated in the video above, we are no in favor of owning at the money weekly calls to play for a breakout, this view now has best odds with a defined risk trade structure if allotted more time, like Dec or Jan expiration.  

So for those looking to play for a breakout, defining risk tp the prior highs is the prudent way to play:


MSFT ($56.75) Buy the Dec 57.5/62.5 call spread for 1.30
  • Buy 1 Dec 57.5 call for 1.54
  • Sell 1 Dec 62.5 call at .24

Rationale – This call spread breaks even at 58.80, below the all time high of 59.97 and provides long exposure up to 62.5 with a max gain at or above that level of 3.70 vs the cost of 1.30. If the stock fails here losses are capped at 1.30 which is less than the implied move just on earnings and this trade idea has until Dec expiration. If the stock continues sideways as it has the past few months the trade idea is at risk of decay so keeping a stop of about half of the cost is wise in that case.


What about for those that are long and want a little protection on the event itself? The key here is to reduce premium spent for a hedge to as little as possible because if you did this all 4 quarters of the year it reduces overall gains in the stock. But when the stock is nearing an all time highs and profits are in had, sometimes it makes sense to spend a little to lock in those profits:


Versus 100 shares of MSFT ($56.75) Sell the Oct 21st 60c vs buying the 55/52.5 put spread for .20
  • Sell 1 Oct 21st 60 call at .25
  • Buy 1 Oct 21st 55 put for .60
  • Sell 1 Oct 21st 52.5 put at .15

Rationale – This hedge costs just .20 and in the case of a decline in MSFT on earnings it protects from 54.80 down to 52.50 with max protection of 2.30 against potential losses in the shares. Above 60 the stock is called away at an effective price of 59.80 which is essentially the all time high from 1999. The best case scenario is a move higher in the shares towards that all time high, at which case the hedge can be closed tomorrow for the small loss against the much greater gains in the shares. This is a good technique for nervous long holders that have profits and would like to let those profits ride while having a safety net on a event sell-off. If the stock declines below the 55 strike it also allows room to buy more shares on the dip for those interested in cost averaging.