Microsoft (NASDAQ:MSFT) stock finally ran into some resistance yesterday after a monster move higher. In fact, Microsoft stock had rallied 35% off the March 23 lows and neared all-time highs at the $190 area. Certainly some of the rapid run up was warranted given the previous drop and diminished impact from the novel coronavirus for Microsoft.
But the red-hot rally has now come too far, too fast. Look for Microsoft’s stock to head lower over the coming weeks.
A Quick Look at Microsoft Stock’s Valuation
The fundamentals are definitely getting stretched for Microsoft. Its price-to-sales ratio is now above 10 and at the highest readings in the past decade. Meanwhile, its forward price-to-earnings ration is nearing 30 and also at 10-year highs.
Other metrics, such as price-to-book and price-to-free-cash-flow, are at similar extremes. Microsoft stock is the largest U.S. stock with a market cap nearing 1.4 trillion. It will be difficult for such a huge company to have growth rates to justify such lofty valuations simply due to the law of large numbers. At some point, even in this momentum melt-up, valuations do matter. I think we are fast approaching that point.
But when looking at stocks to buy, it’s also useful to take a look at the technical perspective.
Examining the Technicals
Microsoft stock is overbought from a technical perpsective. Its nine-day RSI hit 70 and then weakened. The MACD reached its highest readings of the year, but it is now poised to turn negative. Momentum has waned considerably after reaching an extreme. Finally, Microsoft stock is trading at a large premium to the 20-day moving average. When this occurred in the past, it led to meaningful pullbacks to the average. Also note that there is overhead resistance at $187.50.
Most importantly, the stock finally had a down day yesterday after six straight up days. Microsoft stock tried to break out past the previous day’s high of $187.51, but failed. The stock ultimately closed sharply lower on the day (and at the lows) at $182.51.
This type of reversal pattern is often a sign that the trend has come to an end. The buyers have finally become exhausted and the sellers have taken control.
It is even more powerful given the magnitude of the massive rally that preceded it. The momentum traders who have ridden the company’s stock higher will likely begin to exit now that it is no longer going straight up.
I had a similarly bearish outlook in my Feb. 12 MSFT analysis on Microsoft stock, which proved to be prescient, as the stock cratered from all-time highs at $190. However, on March 2, my outlook changed to bullish as shares tumbled below $160. Now that Microsoft has rallied strongly off the lows, my outlook has once again turned bearish, because price does matter. It’s important for traders to always be flexible and change as the market changes.
How to Trade Microsoft Today
Implied volatility (IV) is near the lowest levels since the coronavirus crisis started. This means option prices are comparatively cheap, which favors long option strategies for trades. So to best position for a pullback in Microsoft’s stock, a put diagonal spread makes intuitive sense. It is a defined risk trade that is lower risk than shorting the stock outright. That is an even more important consideration in the current market environment.
As such, I offer the following trade suggestion: Buy MSFT July $180 puts and sell MSFT June $175 puts for a $3.20 net debit.
Maximum risk on the trade is $320 per spread. Ideally, Microsoft stock closes near $175 at June expiration to realize the maximum gain. The trade structure allows additional selling of weekly put options against the long July puts if needed after the June options expire. This can further lower the initial cost of the trade.
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 weekly option and volatility newsletter can visit the Options and Volatility Newsletter website.
