Do You Expect Microsoft To Rise 40%?

| About: Microsoft Corporation (MSFT)

And, really, does it matter?

I always love reading fellow Seeking Alpha contributor Frederic Ruffy's daily option recap. It often gives me the opportunity to explain options-related issues many investors have a difficult time getting their heads around. How do I know this? I receive emails asking me to clear up confusion on a daily basis.

Here's what Ruffy wrote about Microsoft (NASDAQ:MSFT) option activity Tuesday:

... Recent options trades on the software giant include a buyer of 58,000 Jan14 $45 calls for an average of 77.5 cents per contract. The massive premium purchase was not tied to the stock and is a new position in the Jan 2014 calls on Microsoft. 60,000 contracts now traded. Microsoft has been a leader in both the Dow and the Nasdaq this year and is now up 25.7% year-to-date. Still, $45 calls on the stock are 37.8% out-of-the-money ...

That last sentence often triggers confusion among new and even intermediate options traders and investors. Does MSFT need to rise 38% for that call contract to be profitable? No, and the outcome you need to see depends largely on what you intend to do with that call.

Let's consider pricing in the final hour of trading Tuesday. With MSFT stock at $32.68, the January 2014 $45 call fetched $0.78, just above the average the big money trader paid on 58,000 contracts. (Think about that, this person - or firm - plunked down nearly $4.5 million to enter that trade).

The breakeven on the trade, which, for all intents and purposes, only means something if you intend to exercise your right to buy MSFT shares sits at $45.78. Once MSFT trades above $45.78, you could exercise your option to buy MSFT for $45 and start to make money. If you exercise your option at $45.50, you lose $0.28.

Clearly, I have no idea what this trader's intention is. If he or she intends to hold through January 2014 expiration and exercise the option contracts, he or she expects MSFT to appreciate by at least 38% between now and then. If MSFT ended up at $45.80 at expiration, about a 40% pop (as of 12:20 p.m., Pacific time, Tuesday), that's $0.02 above breakeven. On 100 shares of MSFT, that's a profit of $2.00, using the $45.78 breakeven. That $0.02 gain, however, on 58,000 contracts (which controls 5.8 million shares), represents a $116,000 profit.

In all likelihood, the trader has no intention of exercising these options. Consider this. Holding a whole host of other variables constant, if MSFT pops to $35 over the next month or so worth of trading days, that January 2014 $45 call could be worth somewhere in the neighborhood of $1.20. Do the math on 58,000 contracts. That's a sweet profit for one month of your "trouble."

(In case you did not do the math, that hypothetical represents just over a $2.4 million profit on the trade).

I had somebody email me today, noting that he owns a considerable number of Apple (NASDAQ:AAPL) shares. He said he wants to use options in conjunction with his position, but "cannot get his head around" the way they work. My response was simple - get your head around the way they work first and then start thinking about using options.

The first step to learning options has got to be, removing all of the confusing, intervening variables from the picture, getting a handle on the basics and then taking into account all of the things that could go wrong. It can be a long, but worthwhile process.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.