Shares of Microsoft (NASDAQ:MSFT) finally encountered some push back yesterday after a monster rally. Microsoft stock had been up almost 20% so far this year before having a long overdue pullback yesterday. Some of the move higher was certainly warranted given that the earnings report was a major beat on both the top and bottom line. The stock has come too far, too fast however. Time for the red-hot rally to cool over the coming weeks.
![Microsoft Stock Has Finally Hit a Wall](https://investorplace.com/wp-content/plugins/lazy-load/images/1x1.trans.gif)
Microsoft reported earnings on Jan. 29. Earnings came in at $1.51 per share, handily beating estimates of $1.32 per share. Revenues were $36.91 billion, well ahead of consensus of $35.68 billion. No doubt a great report. Microsoft stock moved up strongly on the news, passing Apple (NASDAQ:AAPL) to become the largest U.S. stock with a market cap over $1.4 trillion.
The move higher, however, has pushed valuations to extremes. The current price-to-earnings ratio now stands at over 34 — the highest levels by far in the past 5 years. Price-to-sales is now over 10 and at a decade high. This type of multiple expansion is somewhat acceptable for an emerging high growth company. It is difficult to fathom for the largest company in the U.S. The growth rate for Microsoft will necessarily be tempered simply due to the sheer size of the company. Expect a multiple contraction now that the upside momentum has waned.
Microsoft stock had certainly gotten extremely overbought from a technical perspective. The MACD reached the highest level in the past year before finally weakening yesterday. Bollinger Percent B was well over 1, but subsequently has pulled back. It’s 9-day RSI hit 85, then turned lower. The last time 9-day RSI was this extreme marked a significant top in Microsoft stock. Shares are trading at a large premium to the 100-day moving average of $152.34 — another sign the rally is getting way overdone.
Most importantly, Microsoft stock had a key reversal day yesterday. Shares opened higher and at the highs of the day at the $190.70 area. Microsoft then reversed course sharply to close much lower on the day and near the lows at $184.44. This type of price action is many times emblematic of a top in the stock. The buyers have finally become exhausted and the sellers have taken control.
It is even more powerful after such a strong rally.
How to Approach Microsoft Stock Now
Now that the upside momentum has finally broken, stock traders should look to short Microsoft on any strength. An initial downside target would be a move back to the 20-day moving average near $172. A meaningful breakout to fresh new all-time highs serves as a viable stop out point.
Option traders can take advantage of extremely high implied volatility (IV) which stands at the 100th percentile. This means options prices are currently at the richest level in the past 12 months, favoring option selling strategies when constructing trades.
Selling the March $195/$200 call spread would bring in $1 net premium. Maximum gain on the trade is $100 per spread with maximum risk of $400 per spread. Return on risk is 25%. The short $195 strike price provides a 5.5% upside cushion to the $184.44 closing price of Microsoft stock.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at timbiggam@gmail.com.