Microsoft Stock Still Looks Undervalued - Traders Eyeing Options Plays

Microsoft (MSFT) stock looks undervalued here based on its massive free cash flow (FCF). Its fiscal full-year results are due soon, which could push MSFT stock higher. That would be good for option traders.

The stock closed at $345.24, up $2.58, on Friday, July 14. That puts its overall YTD performance up 44.0%, although, in the last month since June 14, it has risen just 2.34% from $337.34.

Upside Potential in MSFT Stock

Nevertheless, MSFT stock still has considerable upside, as we discussed in our June 27 article, “Microsoft Stock Is Well Below Its Real Value - Making Short Put Plays Profitable."

For example, the article suggested that Microsoft could generate $85 billion in FCF for the next year ending June 30, 2024. At 33x FCF that gives it a market value of $2.8 trillion. This is 9.6% higher than today's $2.56 trillion market cap.

That implies the stock could still rise 10% from here to $379 or so. We can use that price target to help set trading parameters for options plays.

Call and Put Options Plays

In our last article, we discussed shorting out-of-the-money put options at both the $310 and $320 strike prices for expiration on July 21. Since MSFT stock has risen, both of these are options plays are now essentially worthless. 

That is exactly what we want when shorting a put option. The short put trader not only keeps all of the premium received but has no obligation to purchase the stock at the strike prices shorted.

In fact, it might have made sense last time to actually go long the call options in MSFT stock. This has a lot of risk, so I am reluctant to recommend it going forward.

It probably makes more sense to sell short its covered calls instead, just in case the stock has a reversal when the results are released. For example, the call option premiums for the option expiration period ending Aug. 11, at the $365 and $370 strike prices are attractive. They trade for $4.95 and $4.13, respectively.

That means that the covered call player (i.e., buys 100 shares of MSFT and then enters an order to “Sell to Open” 1 call contract) makes 1.43% and 1.20%, respectively. For example, dividing $4.95 by today's price of $345.24 equals 1.43%. 

This is because the trader who sells short the $365 strike price call, which is 5.7% above today's price, immediately receives the $4.95 premium (i.e., $495 per 100 shares for each call contract).

However, note that if MSFT stock rises over $365 or $370 per share on or before Aug. 11, the covered call trader will have to sell their shares at those strike prices.

To get around this, the trader can short out-of-the-money put options. For example, the Aug. 11 puts at the $330 strike price offer a similar premium of $4.78 per put contract. That provides the short put trader an immediate yield of 1.11% (i.e., $4.78/$430).

This means that the trader who secures $43,000 in cash and/or margin with their brokerage firm (which might partially be available by already owning 100 shares of MSFT stock), can then enter an order to “Sell to Open” 1 put contract at the $430 strike price. The account will immediately receive $478.00.

That means that if MSFT stock falls by 4.41% on or before the Aug. 11 expiration period, the short put trader has to use the secured cash/margin to buy 100 shares at $430. But, in return, they get to immediately keep the $478 already credited to their account. 

That is why the short put trader makes a similar yield but with less “capture” risk, in terms of the shares already owned in MSFT stock.

This shows that traders can use the upside in MSFT stock to make money using put and call options. Depending on how well the company does with its upcoming results, MSFT stock could move either way. 

But at least with short puts and calls the trader has a buffer in terms of the income immediately generated.

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