While it’s natural for traders to instinctively scramble for big breakouts or breakdowns, a subtler — and arguably smarter — approach has emerged in Microsoft (NASDAQ:MSFT). By leveraging what the market is willing to give, astute traders can be bearish on MSFT stock, yet still enjoy a trading geometry that allows for significant upside movement.
Following last week’s strong move — with MSFT gaining nearly 11% of equity value — momentum appears to favor the bulls. On Friday, shares closed at $388.45, with the afterhours session signaling more upside action. At the same time, the options market may be mispricing the odds of a further breakout.
Specifically, a bear put spread expiring three weeks from now on May 2 offers a surprisingly favorable risk-to-reward profile. The 415/400 bear put spread — a transaction that involves buying the $415 put and simultaneously selling the $400 put — really captures the eye. That’s because at the moment, the short put strike price is above Friday’s close by 2.97%.
Generally speaking, a bear put spread is a discounted bearish trade. It’s very similar in principle to outright buying a put option. However, the main difference is the simultaneous selling of a put option at a lower strike. The proceeds from this short put partially offset the debit paid for the long put.
Should the security in question fall to or below the short strike price at expiration, the trader collects the maximum reward, which is the difference between the strike prices (multiplied by 100 shares) minus the net debit paid to enter the trade.
Essentially, for the May 2 415/400 bear put spread to be profitable, MSFT stock can do three things: fall down, stay flat or even rise nearly 3%. This kind of risk inversion is relatively rare, warranting a closer look.
Options strategies basically fall under two categories: debit-based or credit-based. The former involves paying cash on the speculation that a specific outcome will materialize. The latter involves receiving cash, underwriting the risk that said outcome will not materialize.
Further, the cash influx received for credit-based options strategies in effect represents how much the position can move against the seller (or risk underwriter) and still walk away without incurring a deficit. This is the “safety margin” that is part and parcel a typical credit strategy such as the bull put spread.
However, because the 415/400 bear put spread allows MSFT stock to rise (and rise significantly) and still be fully profitable, the safety margin actually belongs to the debit buyer. To use the lexicon, theta or time decay works for the speculator, not against. This is pure risk inversion, where debit-based strategies command core characteristics of credit spreads.
Of course, the above MSFT stock isn’t risk-free as the security could potentially break above $400. Still, if you look at a two-year technical chart, you’ll notice that $400 once represented support but will probably shift to resistance.
As well, MSFT stock statistically has a tendency of building off strong momentum in the first subsequent week, while tapering off odds wise over the next four weeks.
Such timing might place the aforementioned bear put spread in the sweet spot.
