A better way to play for a probabilistic pullback in MSFT with cheap puts.
Microsoft (MSFT) is one of two US companies with a market capitalization of more than $2 trillion. MSFT shares are up more than 30% in recent months after a recent low of nearly $220 on Jan. 6.
However, the recent red-hot rally is finally starting to slow down. May sales and exits count as monthly inventory returns for Microsoft were negative on average over the past 5 years.
In addition to the recent share price decline, here are three more very valid reasons to be somewhat skeptical about the ongoing continued strength in MSFT stock in the weeks to come, along with a better way to play.
Microsoft has begun to weaken after failing to break out to new recent highs above $294. Stocks reached overbought levels on both the 9-day RSI and Bollinger Percent B before softening. MSFT trades at a high premium to the 20-day moving average, which has historically led to pullbacks to the average. MACD has just generated a sell signal.
MSFT shares also look a bit overdone on a comparative basis. Microsoft is now showing a slight gain over the past 12 months, while the NASDAQ 100 (QQQ) is still down more than 7% in that period. Normally, MSFT and QQQ move more together, which makes sense considering that Microsoft is the largest weight in the NASDAQ 100 ETF at 12.68%.
The difference in performance spread between MSFT and QQQ has reached an extreme again.
Look for Microsoft to bounce back and become a major underperformer in the coming weeks, as it has in the past.
The current price/earnings ratio (P/E) is back by more than 30x and at the highest multiple of the past year. The last time it was 30x in August was a significant top in Microsoft stock.
It is also well above the average P/E multiple of 27.72 over that time frame. Other traditional valuation metrics, such as price/sales and price/free cash flow, have seen similar increases.
Important to remember that interest rates have risen dramatically over the past 12 months. Normally, this would have a noticeable astringent effect on equity valuation multiples. This makes the recent expansion of MSFT multiples even more pronounced.
In addition, a $2 trillion company that has multiples like this makes it difficult to justify these rich multiples in the future because of the law of large numbers.
Implied volatility (IV) has fallen sharply in MSFT options over the past month. It is now at its lowest level since February and approaching the annual lows of last August.
Notice how the lows in IV almost exactly match the recent highs in the price of Microsoft stock. Implied volatility can be a valuable market timing tool.
Implied volatility is just another way of saying the price of the options. A comparison from about a year ago will shed some light.
Below are the option mounts for the June options from last Friday April 14 and a year ago April 20, 2022. We’ll use the at-the-money June $285 puts for our example.
Comparing the two:
- The share price was almost identical – $286.14 on Friday and $286.36 a year ago on April 20. So slightly lower share price on Friday.
- Days to due date (DTE) were similar: 63 days from Friday and 58 days from 12 months ago. So 5 days longer until the due date on Friday.
All things being equal, the $285 puts in June from Friday should be slightly more expensive than the $285 puts in June from a year ago, as the stock price is lower and has more time to expire.
But all is not equal – IV is now much lower (26.80) than a year ago (33.07). This much lower IV makes the current $285 puts in June more than $2.00 cheaper than the $285 puts a year ago.
The table below puts it all together.
The % column simply takes the option price divided by the stock price to make another useful comparison. The $285 puts in June are now less than 4% of the share price, when the same puts would cost more than 4.5% back then.
Microsoft is technically overbought and fundamentally overvalued. Low levels of implied volatility (IV) are another reason to be bearish. Low levels of IV also mean option prices are cheaper.
Investors looking to hedge or traders looking to speculate can certainly short MSFT shares. But that can be expensive and risky.
Given the current situation, it might be better to consider a defined-risk put buy in Microsoft. It hasn’t been cheaper in a while and loss is limited to the cost of the option – which we just saw is less than 4% of the cost of the stock.
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All the best!
MSFT shares closed Friday at $286.14, down $3.70 (-1.28%). Year-to-date, MSFT has gained 19.61%, versus an 8.26% gain in the benchmark S&P 500 index over the same period.
About the author: Tim Biggam
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim and 3 years as Market Maker for First Options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His main passion is to make the complex world of options more understandable and therefore more useful for the everyday trader. Tim is the editor of the POWR options newsletter. Read more about Tim’s background, along with links to his most recent articles.
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