Uncovering the Strategy: Selling Covered Calls on Microsoft Corp. Uncovering the Strategy: Selling Covered Calls on Microsoft Corp. Uncovering the Strategy: Selling Covered Calls on Microsoft Corp.

Uncovering the Strategy: Selling Covered Calls on Microsoft Corp.

Saxo

Summary:  Microsoft Inc. (MSFT) earnings exceeded expectations and gained 4% last Friday following the tech giant’s announcement of higher quarterly revenue and profit in its fiscal third quarter. With substantial investments in AI to meet the increasing demand of its AI services, Microsoft seems to be in a strong position for growth. While the long-term fundamentals of the company remain as solid as ever, the larger concerns around rich valuations of Mega-cap tech stocks in US remain a cautionary note for investors particularly with Fed’s higher for longer messaging hanging in the backdrop.


What is happening?

Microsoft reported strong earnings that was driven by its Azure cloud-computing business. The company surpassed estimates with a 17% increase in revenue from the previous year, reaching $61.9 billion, while net income grew by 20% to $21.9 billion as AI strengthened the demand for Microsoft’s software and cloud services. The company has indicated that its capital expenditure will continue to increase after investing $14 billion during the last quarter. Microsoft’s CFO Amy Hood said, “We’re seeing the AI demand continue to grow, and so we’ll continue to work to match that”. Both Microsoft and Alphabet Inc. clearly communicated to investors that their investments in AI and cloud computing are yielding positive results.

As part of its broader strategy to develop AI infrastructure globally, Microsoft has revealed its plans to partner with governments, organizations, and communities to offer AI training to 2.5 million people in Southeast Asia by 2025. Following this, the company has committed to investing $1.7 billion in Indonesia over the next four years to build new cloud and AI infrastructure.  The company has also announced a $2.2 billion investment in cloud and AI services in Malaysia, along with the establishment of a data centre in Thailand to boost cloud infrastructure , while providing AI training to more than 100,000 Thais to develop tech. According to CEO Nadella, Microsoft aims to take the lead in the next generation of AI infrastructure that is essential for the future.

What can you do?

For investors holding Microsoft for long-term investment and believe in upside potential of the stock from its AI investments globally but are worried about the rich valuations in the short term, may consider selling covered call options on partial holdings of Microsoft. This strategy enables investors to earn premiums from the call options, providing additional income while they wait for Microsoft’s share price to reach their desired target.

Illustration:

  1. With MSFT stock price at $397.84 on 03 May 2024, selling a call option with a $425 strike price (if you are comfortable selling your MSFT shares at $425) for 1-month expiry (28 days) will yield a total premium of $180.00 ($1.80 x 100 shares).
  2. This gives an annualized yield of 5.8% (1.80/397.84) x (360/28).
  3. If MSFT’s price stays below $425 (strike price) on 31 May 2024(expiry), the option will expire worthless, and the investor gets to keep the premium.
  4. If MSFT’s price rises above the strike price of $425, the investor is obligated to sell the share at $425, but the investor still keeps the option premium thereby making the effective selling price 425 + option premium.
  5. Please note options trade in lot sizes of 100 shares. When an investor sells 1 lot of call option, they are selling call option on 100 shares.
  6. Prudent investors typically sell covered calls only on part of their holdings and keep the upside open on the rest.

When comparing to options with longer maturity, you can observe how this alters the premium you receive and the distance over which you will be able to set the strike.

  • If the investor wishes to receive more premium, the investor can go for an option with a longer expiry. For the same strike at $425, the premium increases to $2.80 as the duration increases to 35 days on 7th June (annualized yield = 6.4%).
  • If the investor is only willing to sell the stock at a higher price but still want to receive a similar premium, the investor has to choose the option with a longer expiry. For a similar premium of $1.25, you can sell the option with the strike $445 and expiry in 49 days on 21st June (annualized yield =2.3%).
  • The table below shows how the premium yield changes as we adjust the strike price and expiry date. The premium yield is subject to many factors including how close the strike is to the current price as well as market moving events surrounding Microsoft. 

Annualised yield of Microsoft options with different Strike and Expiry

Advantages of covered calls

  • Generates passive income. Selling a covered call generates an income via premiums that can supplement the overall return of a portfolio.
  • Relatively low risk. As the risk of being short a call is covered with your stock position, this is a relatively low risk way to trade options.
  • No extra margin required to sell covered callsAs you hold the underlying stock for delivery, there is no extra margin required to sell the same number of covered calls at Saxo.

Risks of trading covered calls

  • Capping your stock’s upside potential. One key risk is the loss of opportunity to profit from your stock’s potential upside above the call option’s strike price.
  • Risk of using covered calls as a proxy for take profit orders: In the example above, it is possible that the stock trades well above $425 through the course of the option but on expiry falls back below $425. Without the option, the investor might have booked the profit at $425 but because the stock was covered by call options, the investor might have waited out until expiry.

Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Capital Markets' Terms of Use, you will find more information on this in the Important Information - Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Capital Markets' website.
This article may or may not have been enriched with the support of advanced AI technology, including OpenAI's ChatGPT and/or other similar platforms. The initial setup, research and final proofing are done by the author.

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