Here’s How to Trade Microsoft Stock at All-Time Highs

Use cheap calendar spread trades to position for a pullback on an overbought and overvalued MSFT

Shares of Microsoft (NASDAQ:MSFT) once again closed at all-time highs. Microsoft stock has rallied nearly 50% off the novel coronavirus-driven lows of late March, with MSFT now up 26% year-to-date.

Microsoft stock
Source: The Art of Pics / Shutterstock.com

Undoubtedly, some of the bounce was warranted given the magnitude of the drop and the relative immunity Microsoft has from pandemic-related slowdowns. The rebound, however, is getting a little too rambunctious.

Expect an overbought and overloved Microsoft stock to pullback over the coming weeks. Here’s why.

Microsoft Stock’s Valuation

Microsoft stock is trading at valuation levels that are more common for emerging growth companies, not the company with the largest market capitalization in the U.S. Its forward price-earnings ratio is above 30 and is at a large premium to that of the S&P 500. Its price-sales ratio just broke above 11, and is at the highest levels of the past decade.

Other metrics like the price-book and price-cash flow ratios are at similar extremes now.

The dividend yield just dipped below 1% and is well below the five-year average of 1.9%. The PEG ratio of 2.4 also points to frothy fundamentals. Microsoft is certainly far from cheap at its current levels.

The Technical Take

Shares of Microsoft are decidedly overbought on a technical basis. The nine-day relative strength index is reflective of that with a reading over 70. Bollinger Percent B is back above 100. Momentum is at recent highs, but finally weakening. Microsoft stock is trading at a large premium to both the uptrend line and the 20-day moving average. This has signaled pullbacks in the past.

Source: The thinkorswim® platform from TD Ameritrade

Most importantly, MSFT saw a bearish doji star formation yesterday. Microsoft stock climbed higher to fresh all-time highs before pulling back to close near the day’s opening price. This failure to hold on to intraday gains is many times the sign of a trend reversal. The buyers have become exhausted and the sellers have taken control.

This trend reversal is especially powerful given the magnitude of the previous rally, along with the fact that the reversal took place at all-time highs. Look for Microsoft to retest the trend line at the $190 area.

Comparing and Contrasting MSFT

A picture is worth a thousand words — as the comparative performance chart below shows. Historically, Microsoft stock is well correlated to both the Nasdaq 100 and the S&P 500. This makes sense since MSFT is the biggest stock in the U.S. Recently, though, that correlation has broken down.

A look back over the past 200 days highlights the massive outperformance for Microsoft stock to both the S&P 500 and Nasdaq 100. MSFT is up over 46% in that time frame while the Nasdaq is up a very respectable 30%. The S&P 500 is languishing with only a 6% gain.

This type of outperformance is even more incredible given that Microsoft stock carries the largest weighting in both of these indices.

Source: Chart by StockCharts.com

I expect MSFT to begin to revert back toward the mean soon given the outperformance. Funds will likely begin to rotate out of Microsoft stock at the end of the quarter to book gains. At the same time, they will rotate in underperforming names. This will be a decided headwind for MSFT over the next few weeks.

Implied volatility has come down sharply in MSFT options, meaning prices are cheaper. This sets up a put calendar spread trade to position for a pullback in Microsoft stock.

How to Trade Microsoft Stock

Buy MSFT July 17 $195 puts and sell MSFT July 2 $195 puts for a $2.00 net debit.

Maximum risk on the trade is $200 per spread. Ideally, Microsoft stock closes near $195 on July 2 expiration to realize the maximum gain. The trade structure allows additional selling of the July 10 weekly options to further hedge the position.

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.


Article printed from InvestorPlace Media, https://investorplace.com/2020/06/microsoft-stock-all-time-highs-time-to-short/.

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