Adding Downside Protection To Microsoft – Seeking Alpha

Microsoft 95 instruction video featuring Friends stars. Screen capture via Bing.

The Nadella Renaissance

Microsoft (NASDAQ:MSFT), two decades after its ’90s glory days, when Friends stars Jennifer Aniston and Matthew Perry made instructional videos for its software, has had a renaissance under CEO Satya Nadella. As reader Franklin Johnson put it in a comment on a recent article by Seeking Alpha contributor Mark Hibben (The (Azure) Sky’s The Limit), “Nadella is the best thing to happen to Microsoft in years.” Indeed, the stock’s up 77% since Nadella took over as CEO.

Screen capture via YCharts.

But last month, Seeking Alpha premium contributor Damon Verial raised the prospect that Microsoft was due for a pullback (Microsoft: Very Likely To Fall Now). Although Verial was bullish on Microsoft’s fundamentals, particularly its potential for continued growth in cloud computing, he was bearish in the near term based on technical and statistical factors. Microsoft is up marginally month to date.

Screen capture via YCharts.

But institutions trading in dark pools seem to share Verial’s near-term bearishness. Recall that dark pools are private exchanges where hedge funds and other institutions can avoid front runners and other predatory traders in public markets. We checked Squeeze Metrics to see the dark pool action in Microsoft this month (we have an affiliate relationship with Squeeze Metrics and are compensated when readers join the site).

Screen capture via Squeeze Metrics.

We’ve highlighted Thursday in the chart above, where the DPI, or Dark Pool Indicator, was 37%, meaning that 37% of the dark pool trades in Microsoft were buys that day (if you’re wondering how there can be a mismatch between dark pool buys and sells, it’s because dark pool sales are often routed to intermediaries such as high frequency trading market makers). That’s a bearish DPI, as is any figure below 50%. In the 16 trading days so far this month, the DPI was neutral (50%) once, and in bearish territory the other 15 trading days.

Adding Downside Protection To Microsoft

If you’re long Microsoft and as bullish about its cloud prospects as Verial and Hibben, but want to limit your downside risk over the next several months in the event it pulls back, we’ll look at two ways of optimally hedging it below (if you’d like a refresher on hedging terms, see the section titled “Refresher on Hedging Terms” here).

You can use the method we described in this article to find optimal hedges manually, but we used the Portfolio Armor iOS app for these examples. In both examples, the hedges are designed for investors who are unwilling to tolerate declines of more than 13%.

Uncapped Upside, Higher Cost

These were the optimal puts, as of Thursday’s close, to hedge 500 shares of MSFT against a greater-than-13% decline by late July.

Screen capture via the Portfolio Armor iOS app.

The cost of this protection, as you can see above, was $505, or 1.56% of position value (calculated conservatively, assuming you bought the puts at the ask price).

Upside Capped At 8%, Lower Cost

We used 8% as a cap here, because that was our website‘s potential return estimate for Microsoft over the next several months.

As of Thursday’s close, this was the optimal collar to hedge 500 shares of MSFT against a greater-than-13% drop by late July, without capping your upside at less than 8% by then.

Screen capture via the Portfolio Armor iOS app.

The put leg of this collar (above) uses the same strike as the optimal puts, so the cost is the same: $505, or 1.56% of position value. But the income generated by selling the calls (below – calculated conservatively, using the bid price) was nearly as much: $495, or 1.53% of position value.

Screen capture via the Portfolio Armor iOS app.

So the net cost here was negligible, $10. And since it was calculated conservatively here, it’s likely you could have opened this hedge for less.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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