Why Microsoft Is Really Trading Down Today (Hint: It Has Nothing To Do With Earnings)

Benzinga's PreMarket Prep airs every morning from 8-9 a.m. ET. During that fast-paced, highly informative hour, traders and investors tune in to get the major news of the day, the catalysts behind those moves and the corresponding price action for the upcoming session.

On any given day, the show will cover at least 20 stocks determined by co-hosts Joel Elconin and Dennis Dick along with producer Spencer Israel.

Many investors are wondering why Microsoft MSFT is trading in the red after such a stellar earnings report. In reality, it has nothing to do with Microsoft. The reason has everything to do with Alphabet Inc GOOG and the effects of ETF arbitrage.

Alphabet Blows It Away: Just before Microsoft reported results. Alphabet blew the Street away with outstanding results. The company reported quarterly earnings of $26.29 per share, which beat the analyst consensus estimate of $15.88. The company reported quarterly sales of $55.31 billion, which beat the analyst consensus estimate of $51.68 billion by 7%.

To put the icing on the cake, the company announced the board of directors approved a $50 billion class C capital stock buyback. In the Street’s view, the buybacks show the confidence the company has in its future earnings growth as the stock trades at an all-time high.

As expected, shares of Alphabet went into orbit.

Index Arbitrage Traders Need To Keep Pace: Keep in mind, the combined Alphabet companies represent 3.81% of the entire S&P 500 index and 6.93% of the Invesco QQQ QQQ, not to mention the other indexes of which it's a large component.

As Alphabet shot up following its earnings report, index arbitrage traders were scrambling to purchase shares of the related indexes and sell other stocks in an effort to keep the indices in line with their components.

The problem was, in the after-hours market there were only so many offers to lift in the QQQs, and there wasn’t as much liquidity in the index’s other components. This created an arbitrage quagmire.

Microsoft Rescues The Arbs: On any other day, Microsoft’s report may have created a buying frenzy in the issue.

The company reported quarterly earnings of $1.95 per share, which beat the analyst consensus estimate of $1.78. The company reported quarterly sales of $41.70 billion, which beat the analyst consensus estimate of $41.03 billion.

Other market pundits will come up with some other kind of excuse why the issue is in the red, but it's all in the arbitrage math.

With Microsoft being 5.56% of the S&P 500 index and 9.5% of the QQQ, arbs realized they could just as easily keep the indexes in-line to account for Alphabet’s rise by selling Microsoft. And that's exactly what happened.

This concept is not an easy one to follow and not understood by a large percentage of the investment world. If you listen to Dennis Dick’s dissertation on the subject on Wednesday’s "PreMarket Prep" Show, you will gain a unique perspective on the markets that can be another tool in your trading toolbox.