Adding Protection To Microsoft On The Bounce

Summary

• Last week, a Seeking Alpha contributor warned that shares of Microsoft were overvalued.
• In that assessment he was aligned with Seeking Alpha Essential's Quant Rating, which gives Microsoft an "F" for value.
• Given its extended valuation, and the broader economic risks associated with the coronavirus, I show ways cautious Microsoft bulls can take advantage of the market bounce to hedge their shares.
• Looking for a helping hand in the market? Members of Bulletproof Investing get exclusive ideas and guidance to navigate any climate. Get started today »

Microsoft Belgium encourages children to learn about technology (photo via Microsoft's Twitter account).

Taking Advantage Of The Bounce To Add Protection

Last week, Seeking Alpha contributor Oleh Kombaiev warned that Microsoft (MSFT) shares were overvalued ("Microsoft - Emotions = Overvaluation"). In that assessment, Kombaiev has some backing from Seeking Alpha Essential's Quant Rating, which gives Microsoft an "F" for valuation.

Screen capture via Seeking Alpha.

Although the overall Quant Rating for Microsoft is on the bullish side of neutral, as you can see above, that rating doesn't take into account the broader economic risks of the COVID-19 coronavirus. As I wrote last week ("Time To Immunize Your Portfolio"), the economic risks of the virus may not be fully appreciated yet. Seeking Alpha contributor Daniel Nevins, CFA attempted to quantify those risks ("Straightforward Calculations On COVID-19 Risks"), and concluded that given likely global diffusion rates, a moderate to severe global recession is possible. Given those risks, and Microsoft's current, extended valuation, I'll show a couple of ways cautious Microsoft bulls can take advantage of the market bounce to stay long while strictly limiting their risk (hedging during a market bounce can be less expensive).

Adding Downside Protection To Microsoft

For these examples, I'll assume you own 200 shares of Microsoft and can tolerate a decline of as much as 20% over the next six months, but not one longer than that. I'm using 20% here to strike a balance between not taking too much risk and not costing too much to hedge, but of course, if you hedge, you should pick a decline threshold that's in line with your risk tolerance.

Uncapped Upside, Positive Cost

As of Monday's close, these were the optimal, or least expensive, put options to protect 200 shares of Microsoft against a greater-than-20% decline by mid-September.

Here, you can see the cost was $1,150, or 3.33% of position value, calculated conservatively, using the ask price of the puts (remember that, in practice, you can often buy and sell options at some price between the bid and ask). That worked out to an annualized cost of 6.1% of position value.

Capped Upside, Negative Cost

If you were willing to cap your possible upside at 15% by mid-September, this was the optimal collar to protect you against the same, greater-than-20% decline over the same time frame.

The cost this time was negative, meaning you would have collected a net credit of $50, or 0.14% of position value, when opening this collar, assuming you placed both trades (buying the puts and selling the calls) at the worst ends of their respective spreads. That worked out to an annualized cost of -0.27% of position value.

Wrapping Up: Another Way To Lower Hedging Costs

For both of the hedges above, I used the default of looking for expiration dates approximately six months out. You may be able to get less expensive optimal hedges at different expiration dates. For example, if you were willing to keep the same parameters otherwise, extending your expiration date from September to next January would have lowered the cost of the optimal collar above (i.e., given you a larger net credit). That's an approach to consider if you think the risks we touched on above are likely to extend into the new year. On the other hand, if you think we'll be through the worst of the COVID-19 headwinds in a few months, you could scan for optimal put options expiring in June instead of September. Those will be less expensive than the first hedge shown above.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.