Microsoft short strangle trade pitched after stock's earnings surge

Microsoft short strangle interest is getting attention after the stock jumped on its fiscal fourth-quarter earnings, with CNBC contributor Mike Khouw outlining an options income trade for investors who think the next move may be contained. For retail investors, the idea matters because it shows how options traders can try to collect premium after a big earnings move, while taking on risks that can be far larger than the cash received upfront.

Khouw said Microsoft gained about $450 billion in market capitalization in one trading day after earnings. CNBC market data showed Microsoft recently trading at $458.04, up $6.94, or 1.54%, at 11:39 a.m. EDT.

His view is that the earnings announcement removed the near-term “binary event” risk, meaning the kind of one-time catalyst that can send a stock sharply in either direction. He also said that, despite debate around Microsoft’s elevated artificial intelligence spending, the company’s core business remains in good shape.

What is the Microsoft short strangle trade?

Khouw’s proposed trade is selling the August 21 weekly $412.50 put and the $485 call, a position known as a short strangle. A short strangle means selling an out-of-the-money put and an out-of-the-money call at the same time, collecting option premium while betting the stock stays between the two strike prices through expiration.

According to Khouw, the trade collects $7.30 per share, or $730 per strangle. He broke that down as $3.50 from the put side and $3.80 from the call side.

Khouw said the $412.50 put is placed near downside support and gives the trade a break-even price of $405.20 after subtracting the premium received. If the put is assigned, the seller would buy Microsoft shares at an effective cost of $405.20, according to his calculation.

On the upside, Khouw said the $485 call sits above nearby resistance and would require Microsoft to rise more than 8.5% in 21 days for that side of the trade to become pressured. He noted that $485 was also an area from which Microsoft fell sharply in late January.

How much income does the trade target?

Khouw calculated the premium as a standstill yield of about 1.6% over 21 days, based on Microsoft’s stock price at the time. He said that works out to roughly 28% annualized.

That annualized figure is a way of expressing a short-term return as if it continued for a full year. It is not a guarantee that the trade can be repeated at the same terms, and options prices can change quickly as the stock moves or volatility changes.

Khouw attributed part of the setup to post-earnings implied volatility falling and time decay becoming more powerful with 21 days left until expiration. Implied volatility is the options market’s estimate of how much a stock may move, and time decay is the loss of option value as expiration gets closer.

What are the risks?

Khouw highlighted a major caveat: unless the call is sold against an existing long stock position, the short call can create theoretically unlimited losses. That is because a trader who sells an uncovered call may have to deliver shares if the stock rises sharply, and a stock’s upside is not capped.

If the call side is assigned, Khouw said the trader would either open a short position or reduce an existing long position at an effective price of $492.30, including the premium. He said the odds of Microsoft doubling before expiration are low, but the risk still exists in theory.

Khouw also said Microsoft trades at about 22.6 times forward earnings, which he described as near the midpoint of its 20-year valuation range. In his view, that valuation, combined with Microsoft’s revenue growth and enterprise cloud position, supports a defined-duration short-volatility setup rather than a bet on a sustained breakout or breakdown.

This story draws on original reporting from CNBC.