Microsoft Put Option Premiums Are at High Levels, Worth Shorting for Income

Microsoft (MSFT) stock is off over 2% in the past week, and down 8.75% since mid-day Dec. 14. It closed Dec. 23 at $238.19 off 2.5% in that day alone. The market is punishing the stock. This has raised its put option premiums for out-of-the-money put strike prices, making them ideal to short. That makes it an ideal opportunity for value investors to create short-term income plays.

Microsoft's Fundamentals

Microsoft is one of the few tech companies that is an extremely strong and durable cash flow-producing generator. Last quarter its Q3 revenue was up 11% YoY but diluted earnings per share (EPS) was down 13%. 

But Microsoft still generated free cash flow (FCF) of $16.9 billion, albeit down 10 percent year-over-year. That still represents almost one-third of its quarterly revenue of $50.1 billion. As for its outlook the company said it expects “materially weaker” PC demand in the coming quarter. But its cloud business is still expected to be “healthy.”

Since analysts still project revenue to reach $213.4 billion for the year ending June 30, its FCF could be as high as $66.36 billion. That is still above the $63.3 billion in FCF it made last year.

Moreover, if MSFT stock were to trade at its average historical FCF yield of 3.0% the market cap will eventually rise back to $2.21 trillion (i.e., $66.36b/0.03=$2,210 billion). Since MSFT has a market cap today of just $1.82 trillion, that implies MSFT stock could rise 21.4% to at least $289 per share. This is likely where it will trade sometime in the next six months, based on these fundamentals.

It also means that the put options, which are very high now, are worth shorting to create income plays.

Shorting OTM MSFT Puts for Income

MSFT stock trades for $238.19 as of Dec. 22. But its puts expiring Jan 27, 36 days from now, show that the $210 strike price puts have a midprice premium of $2.01 per contract. That represents an immediate yield of almost 1.0% (i.e., $2.01/$210 = 0.96%) in a little over one month. That also represents an annualized return of 11.5%.

This means that if an investor secures $21,000 in cash and/or margin with his brokerage firm, he can put in an order to “sell to open” at the midprice of $2.01 for the $210 strike price. This price is now 11.84% below the present stock price. So, MSFT stock would really have to tumble in the next month before the investor would have to buy shares at $210.00 per share.

Keep in mind that it's likely that Microsoft may have announced its earnings for the quarter ending Dec. by then, as is its usual practice. So, unless EPS is likely to seriously decline, it may not actually reach that price. But even if it does, the investor will be able to get in at a significant discount from today's price.

That is why value investors are looking very closely at shorting out-of-the-money (OTM) put options to create income each month.

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