Microsoft Corp. MSFT has dropped 16% over the last month and has breached previous support at its 50-week moving average. But a disconcerting pullback for some means a buying opportunity for others, and on Thursday, analysts with FBR upgraded MSFT shares to “outperform” from “market perform.” (This is essentially a move to “buy” from “hold”).
The new MSFT bulls cited a price-to-earnings ratio of 11.2 and the stock’s recent underperformance of its technology peers, presenting investors with a potential opportunity to buy on the dip.
For bullish investors who don’t want to simply buy shares (or who want an opportunity to hedge their position), there are many options-trading strategies to explore. The same is true for traders who disagree with FBR’s thesis and who want to take advantage of potential downside in the shares. Two hypothetical options trades on the stock – one bullish, one bearish – are outlined below. Remember these are merely examples, not recommendations. Consider your own risk/reward parameters and personal trading goals before executing any new trades.
*Prices given as of Thursday afternoon. MSFT is trading at $26.
Bullish Option Strategy: Collar
The “collar” strategy is designed for investors who have a relatively positive outlook on the underlying stock but who still want to exhibit a bit of caution. A collar – comprised of a long stock position, a long put, and a short call – can be used by traders who want to collect premium on a stock they own but also wish to hedge themselves in the event of a sharp drop in the shares.
For every 100 shares of Microsoft purchased (or already owned), an investor can buy one January 22.50 put for $1.42 and sell one January 29 call at $1.29, paying an overall net debit of 13 cents (note that both options are out of the money). Breakeven for a hypothetical collar, with the stock trading at $26, is $26.13, or the stock price plus the debit paid for the collar.
If MSFT rallies above 29 by the time these options expire, the stock will be called away and the collar trader collects the maximum profit of $2.87, which is the call strike minus the stock price minus the net debit. The maximum loss for the collar is capped at $3.63, which is the breakeven price minus the put strike. If the options expire and the stock is not called away, the investor can choose to hold onto the long stock position, which comes with unlimited reward and significant risk down to the zero mark or execute another option overlay to collar the returns once more.
Bearish Option Strategy: Bear Call Spread
Despite recent volatility in MSFT shares, the stock’s long-term trend has been rather predictable. In fact, the shares have spent very little time below the $20-$22 area since the late 90s! For this reason, an aggressively bearish strategy, such as a long put, might not be as reasonable as a more limited risk limited reward strategy. A bear put spread can be executed by simultaneously buying the October 26 put and selling the October 24 put, paying a net debit of 80 cents.
If MSFT is trading below the $24 level when these options expire on October 15, the trader collects the maximum potential profit of $1.20 (the difference in strike prices minus the debit paid). The maximum loss is 100% of the debit paid, and this occurs if MSFT is trading above $26 at expiration. Breakeven for this strategy is $25.20, or the long put minus the debit paid. If MSFT is trading anywhere below this level when the options expire, the trade will be profitable.
Compare the OptionsHouse rates for stock options with other brokers. For investors who are new to options and want to try out their trades without committing real money, practice using a free virtual trading account.
Photo Credit: andymangold
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