Stock Options To The Rescue! Microsoft (MSFT)

| October 19, 2012 | 0 Comments

Windows 8Today we’re going to look at Microsoft (MSFT) and how you can use options to reduce your risk and give you upside potential. 

Here’s what happened…

MSFT shares are down 3% from $29.50 to $28.55 after reporting weak quarterly revenue and earnings that fell short of analysts’ estimates. 

Here’s the deal…

MSFT was expected to earn $0.56 per share on $16.37 billion in revenue. 

However, revenue came in at $16 billion.  It was an 8% drop in revenue from the same quarter last year.  And about 2.5% shy of estimates. 

Sales of MSFT’s flagship product, Windows operating system, were weak ahead of the much anticipated release of Windows 8. 

But that’s not unusual.  MSFT usually experiences a decline in sales the quarter before the launch of a new version of Windows. 

And last quarter was no exception.  Sales of Windows were down 33% year-over-year.

The weak revenue trickled down to profits as well.  They only managed to earn 53 cents per share, a 3 cent per share earnings miss. 

Here’s the kicker…

Microsoft’s launching Windows 8 next week.  They’re expecting it to breathe new life into the software company that’s largely missed out on tablets and mobile.

The new version of Windows is the biggest overhaul to the operating system since they launched Windows 95.  It’s designed to tie together PCs, tablets, and phone software with the same look and feel across all three platforms.

However, the early reviews have been mixed.

The new software is so radically different than previous versions that it could leave many users feeling lost. 

In other words, MSFT’s fate is hanging in the balance.

They could succeed in creating a product that bridges the divide between PCs, tablets, and smartphones.  Or they may have just shot themselves in the foot and destroyed the greatest software franchise of all time.

Here’s what to do now…

If you’re familiar with MSFT, you’re probably not all that surprised by the weak quarter… it’s not the first time they’ve fallen short of expectations leading up to the launch of a new version of Windows.

But the radical overhaul they’ve given Windows this time around is different.  The success or failure of the new product could lead to wild swings in the stock going forward.

What’s more, if Windows 8 is a complete failure, it could be a misstep the company doesn’t recover from for years.

As such, investors who own the stock should take steps to limit their risk in case Windows 8 bombs.  But you’ll also want a way to reap the rewards if Windows 8 is a smash hit.

Let’s assume you bought 100 shares of MSFT at $30 earlier this year in anticipation of the stock soaring on the release of Windows 8.

Selling MSFT and buying the MSFT January 2014 $30 call option for $2.15 will reduce your risk and give you upside potential if MSFT soars next year.

By selling your MSFT stock at $28.50 per share, you’re taking a $150 loss.  And it will cost you $215 to buy the January 2014 $30 call option.

This strategy limits your losses to the loss on the sale of the stock plus the cost of the option.  In this case, your losses are capped at $365 or 12% of your initial $3,000 investment. 

But holding onto MSFT has much more risk. 

If customers don’t adopt Windows 8, the stock could go into a freefall.  The stock would only need to fall to $26.35 for the losses on the stock to exceed the max loss if you sell now and replace the stock with a call option.  And the downside on the stock if Windows 8 flops is much lower than $26.35.

What’s more, buying a call option gives you the ability to recoup your losses if the stock rebounds next year. 

Don’t forget, these call options don’t expire until January of 2014.  That gives you nearly 15 months for Microsoft to establish Windows 8.  You’ll breakeven on the trade if MSFT is trading for exactly $33.65 when the option expires.

If MSFT is above $33.65, it will generate profits. 

In essence, replacing MSFT with a call option dramatically reduces your risk if Windows 8 flops and it gives you the ability to profit if Windows 8 is a success. 

With the fate of the stock riding on the release of a product that’s receiving mixed reviews, I’d much rather own a call option with limited downside than risk it all by owning the stock.

Good Investing,

Corey Williams

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Category: Stock Options To The Rescue!

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.