Microsoft: Looking Sweet for Option Combinations

Microsoft (MSFT) closed last Friday at $28.05 /share down from its November 2, 2007 high of $37.50. With calendar year 2008 earnings projected at $2.00, that means MSFT now trades at just about 14 times this year’s estimate.

When was the last time Microsoft was offered at this valuation? Never.

Why is it so cheap? Uncertainty about the Yahoo! (YHOO) situation.

When will that be resolved? Who knows?

How can you profit regardless of what happens? By purchasing MSFT shares and selling both call and put options in a combination trade.

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My minimum expectation for MSFT shares is that they’d trade for 15 times earnings (with or without a total or partial Yahoo! acquisition). I figure MSFT to be at least $30 again by year-end 2008.

Is a $30 target reasonable? Microsoft shares have traded between $30 and $60 during 11 of the past 12 years. Only 2005 saw a lower peak level of $28.30, and that came when FY EPS were $1.16 rather than FY 2008’s $1.89 estimate for this June.

Here are two slightly different combinations that make sense for good gains but have relatively low risk.

[I’m using 1000 shares for illustration but any multiple of 100 shares works for these examples].

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Quite conservative yet with good potential:

At expiration on January 20, 2009:

• If MSFT shares are above $27.50 /share [as they are right now]:
• The puts you sold will expire worthless [a good thing for you- the seller].
• The calls you sold will be exercised. You will sell your shares for $27,500.
• You will have no shares, no options and $27,500 in cash for your outlay of $22,700.
• That’s a $4,800 cash-on-cash profit on $22,700 or + 21.1% over the 8 months until expiration date. Not too shabby considering this maximum profit occurs if the shares go up, stay unchanged or even if they drop by 2% to $27.50.

What’s the risk?

Here’s how to figure your ‘break-even’ on this combination:

• On the shares you bought, it’s the $28.05 purchase price less the $3.05 call premium received. You aren’t behind unless the shares go below $25 - a margin of safety of 10.8% from your starting point.
• Your puts have a break-even point of the $27.50 strike price less the $2.30 put premium received. You’re in profit as long as MSFT stays above $25.20 – a margin of safety of 10.16% from your starting point.

Your total risk, then, is to end up owning 2000 shares of Microsoft at an average net cost of $25.10 /share. That price is lower than the absolute lows hit since June 2006. Earnings per share have risen about 35% since then. If 2008 earnings come in as expected your final cost would be about a 12.5 P/E.

Longer, more aggressive and with bigger upside:

At expiration on January 20, 2009:

If MSFT shares are above $30 /share [up $1.95 or + 7%]:

• The puts you sold will expire worthless [a good thing for you- the seller].
• The calls you sold will be exercised. You will sell your shares for $30,000.
• You will have no shares, no options and $30,000 in cash for your outlay of $19,250.
• That’s a $10,750 cash-on-cash profit on $19,250 or + 55.8% over the 20 months until your options expire. This maximum profit occurs only if the shares go up to $30 or better by expiration date in January of 2010.

Think about it though. A 7% rise in Microsoft shares over by January 2010 brings us a 55.8% gain over 20 months.

What’s the risk?

Here’s how to figure your ‘break-even’ on this combination:

• On the shares you bought, it’s the $28.05 purchase price less the $3.80 call premium received. You aren’t behind unless the shares go below $24.25 - a margin of safety of 13.5% from your starting point.
• Your puts have a break-even point of the $30 strike price less the $5 put premium received. You’re in profit as long as MSFT stays above $25 – a margin of safety of 10.87% from your starting point.

Your total risk, then, is to end up owning 2000 shares of Microsoft at an average net cost of $24.63 /share. That price is lower than the absolute lows hit since June 2006. Earnings per share have risen about 35% since then. If earnings come in as expected your final P/E would be about 11 times FY 2009 projections.

I would be very content to own shares of MSFT at the worst-case prices from the above combinations. I think the odds are heavily tilted towards seeing the best-case scenario play out.

You shouldn’t enter into these trades, though, unless you are prepared for, and financially capable of, living with the ‘double’ position in Microsoft that could result if the unexpected should occur.

Disclosure: Author is long MSFT shares and short the MSFT options mentioned.

Comments

[chinaRetail:]

Yea, but what if US recession really kicks in or they choke on the Yahoo deal. MSFT could go to $20. It's much safer to leave the put side out of the equation. Even safer would be to Invest in a sector that is really performing well. China diamonds sales grew 100% last year. Check out JADE.

2008 May 28 08:00 AM

[j.lauberge:]

get a real job!

2008 May 28 04:16 PM

[bill d:]

Sounds like you ae a working stiff.
sucker.

2008 May 28 05:49 PM

[truthinvesting:]

GO to gurufocus and you will see his recommendation for buying CFC puts last summer.

2008 Jun 01 12:19 PM