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 over $2 trillion. MSFT stock has risen more than 30% in the past few months after hitting a recent low near $220 on Jan. 6.
The recent hot rally is finally starting to slow down. Sell ​​in May and leave applies to Microsoft, as monthly stock returns have averaged negative over the past 5 years.
Besides the recent tear higher, here are three other very valid reasons to be somewhat skeptical of continued and sustained strength in MSFT stock over the next few weeks, as well as a better way to play.
Techniques
Microsoft is starting to weaken after failing to reach recent new highs above $294. Stocks hit overbought readings on both the 9-day RSI and the Bollinger B percent before softening. MSFT is trading at a steep premium to the 20-day moving average, which has led to pullbacks to the average in the past. MACD has just generated a sell signal.
The MSFT action also seems 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% over this period. Normally, MSFT and QQQ tend to move more in tandem, which makes sense given that Microsoft is the largest weighting in the NASDAQ 100 ETF at 12.68%.
The performance differential between MSFT and QQQ has again reached an extreme.
Expect Microsoft to come back and be a big underperformer over the next few weeks, just as it has in the past.
Assessment
The current Price/Earnings (P/E) ratio is back above 30x and at the highest multiple of the past year. The last time it hit 30 in August, it marked a significant high in Microsoft stock.
It is also well above the average P/E multiple of 27.72 during this period. Other traditional valuation metrics, such as price/sales and price/free cash flow, saw a similar rise.
It is important to remember that interest rates have risen dramatically over the past 12 months. Normally, this would have a noticeably contractive effect on equity valuation multiples. This makes the recent expansion of multiple MSFTs even more pronounced.
Additionally, a $2 trillion company carrying these types of multiples makes future growth rates difficult to justify these rich multiples simply due to the law of large numbers.
Implied volatility
Implied volatility (IV) has fallen sharply over the past month in MSFT options. It is now at its lowest since February and is approaching the yearly lows of last August.
Notice how IV’s lows line up almost precisely with recent Microsoft stock price highs. Implied volatility can be a valuable market timing tool.
Implied volatility is just another way of telling the price of options. A comparison from about a year ago will help shed some light.
Below are the option setups for June options from last Friday, April 14 and a year ago on April 20, 2022. We are using June put options at $285 for our example.
Comparing the two:
- The stock price was almost identical – $286.14 on Friday and $286.36 a year ago on April 20. So share price slightly lower on Friday.
- Days to expiration (DTE) were similar – 63 days since Friday and 58 days since 12 months. So 5 more days until expiration on Friday.
All things being equal, Friday’s $285 June put options are expected to be slightly more expensive than the $285 June put options from a year ago, as the stock price is more low and there is more time before expiration.
But all is not equal—IV is much lower now (26.80) than it was a year ago (33.07). This much lower IV makes the current June $285 put options more than $2.00 cheaper than the $285 put options a year ago.
The table below brings it all together.
The % column simply takes the option price divided by the stock price to create another useful comparison. June’s $285 puts now represent less than 4% of the stock price, when the same puts back then would cost more than 4.5%.
Microsoft is overbought on a technical basis and overvalued on a fundamental basis. Low levels of implied volatility (IV) are another reason to be bearish. Low IV levels also mean that option prices are cheaper.
Investors looking to hedge or traders looking to speculate can certainly short MSFT shares. But it can be expensive and risky.
Given the current situation, it may be best to consider a definite risk purchase from Microsoft. It hasn’t been cheaper for a while and the loss is limited to the cost of the option – which we just saw is less than 4% of the stock’s cost.
POWR Options
What to do next?
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All my wishes!
Tim Biggam
Editor, POWR Options Newsletter
MSFT shares closed at $286.14 on Friday, down -$3.70 (-1.28%). Year-to-date, MSFT has gained 19.61%, compared to an 8.26% rise in the benchmark S&P 500 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 Chief Options Strategist at ThinkorSwim and 3 years as a Market Maker for First Options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade “Morning Trade Live” network. His primary passion is to make the complex world of options more understandable and therefore more useful to the everyday trader. Tim is the editor of the POWR Options newsletter. Learn more about Tim’s journey, as well as links to his most recent articles.
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