Incoming Surge in Microsoft Corp. Solid patterns formed!

In this brief, we will explore a bit more advanced trading strategies to counter the movement in Microsoft until its earnings with multiple options. The main goal here is to have maximum capital exploitation before and beyond earnings. In light of this, we deployed a couple of strategies in this underlying that will go well in either case when the stock goes up, goes up slightly, and falls slightly before taking off upwards. Let us look at them one by one.

Alert Date: Oct 07, 2024

Market Focus: Equities & Options

Time Horizon: 14-day swing

Distribution Time: Post-Market

Market Overview

• During the week, US equity indexes saw gains, driven by positive quarterly earnings from banking giants and an increase in bets favoring slower monetary policy easing. The Dow Jones Industrial Average closed at 42,863.93, the Nasdaq Composite at 18,342.94, and the S&P 500 at 5,815.03. Technology, industrials, and financials were the top-performing sectors, with Nvidia, Wells Fargo, and JPMorgan Chase leading among mega-caps.

  
  

  Tesla's stock dropped 8.78% in premarket trading after the company unveiled its robotaxi without providing production or regulatory details. Adjustments were made to close the sell leg of the TSLA bull call spread and average down the cost of the buy leg Nov 280 call. The plan is to exit around earnings with additional strategies for volatility crush option trades.

  
  

  JPMorgan's Q3 earnings unexpectedly rose, with sales surpassing estimates, driven by gains in investment banking. Consumer spending remains healthy, credit trends are benign, and fee income exceeds expectations. Morgan Stanley also displayed strength, following JPMorgan's lead.

  
  

  The consumer price index remained unchanged month-over-month in September but was higher than forecast. The producer price index fell more than forecast in September, with the core PPI in line. The probability of a 25-basis-point rate cut on Nov. 7 climbed to 90%, while the likelihood of a pause decreased to 10%.

  
  

  Regarding international news, Israel's security cabinet is yet to agree on its response to Iran's missile attack, with the US and Israeli positions narrowing. President Joe Biden has suggested that Israel's retaliation should be "proportional." Monitoring the situation, the plan is to hedge positions with new option strategies in the volatility index $VIX if deemed necessary.

Technical Analysis

• Major Support/Resistance Levels for Stock Microsoft Corp.:

  • Support: 413, 406, 401.3

  • Resistance: 421, 426, 433

• Indicators:

  • Moving averages (20-day, 50-day 200-day)

  • MACD (Moving Average Convergence Divergence) signals buy

  • Bullish divergence on both daily and weekly charts between the price and MACD

  • Fibonacci extension levels are drawn to point out key levels for exit

  • Volume Profile looks good for the week basing and gaining momentum

  • True range is also tight with a triangle formation, and the price increases the potential for a breakout as it nears the tip of the triangle constrained by the up and lower bounds, as shown in the picture. Major moves could take time, though as we see that on a weekly time frame.

  • Has strong support on daily time frame

  • No other conflicts on lower and higher time frames.

Chart

Trade Rationale

Choose either equities or derivatives, not both, for which the risk will increase acting against our intentions

Equities

• Asset/Instrument: Microsoft [Stock]

• Ticker: MSFT

• Trade Type: Long

• Entry Point: 413

• Exit Target: 420 / 425 / 432

• Stop-Loss: 395

• Position Sizing: 5% of the portfolio (don't risk more)

Derivatives Trade 1

Asset class: Options

Trade Type: Call Butterfly Spreads (2 trades) and adjusted later to naked Long Call. Read more below.

Buy 1 MSFT Nov15 415 Call for a debitSell 2 MSFT Nov15 425 Call for a credit

Buy 1 MSFT Nov15 435 Call for a debit

Net debit paid to open $1.10/ contract

Probability 17%

Return/Risk 6.11 (very good)

Max Risk 3% (split 5% into 2 trades with 2% in trade 2)

Margin/max loss $110 (debit paid to open)

Derivatives Trade 2

Asset class: Options

Trade Type: Call Butterfly Spreads and adjusted later to naked Long Call. Read more below.

Buy 1 MSFT Oct25 415 Call for a debit

Sell 2 MSFT Oct25 425 Call for a credit

Buy 1 MSFT Oct25 435 Call for a debit

Net debit paid to open $1.68/ contract

Probability 23%

Return/Risk 3.8

Max Risk 2% (split 5% into 2 trades with 3% in trade 1)

Margin/max loss $168 (debit paid to open)

Outcome on October 9, 2024:Closed Trade 1 in profit $6 /contract

Closed Trade 2 in profit $18 /contract

Total Profit $24 /contract

Total Net Profit on 2 trades $480 (20 contracts)

Return on Capital (ROC) 8.6%

Opened another Trade on October 9, 2024:Buy MSFT Dec 20 425 Call @ $17.33

What Happened? Why we did what we did?

Let us first understand the chart of the Microsoft. If you look closely, there are mainly the following factors that contribute to a bullish case:

1. Bullish divergence between price and MACD

2. Strong Support on both daily and weekly chart that is long-standing - look left

3. Fibonacci extension levels are drawn from Aug5th bottom (A), Aug22nd top (B), and Sep6 bottom (C) form a 100% extension level at Sep17 top (D) at 441.85 high level

4. Constrained triangle formation is shown in green with the price being at the bottom of the triangle (get your copy of The Retail Core PDF, which explains all important patterns)

5. Gaining volume and basing around with rising momentum - about to explode and release along the way - could take a couple of weeks, though

With these established, it is clear that the stock is going to move higher. But which vehicle is right for our entry to exploit? We chose the Butterfly spread that performs really well in a high IV environment and when the price moves slightly towards the sold leg of the option at 425 Call, both for the October and November series.

Butterfly Spread:

The butterfly options strategy is a neutral trading strategy that profits from low volatility. Here’s a beginner-friendly breakdown:

A butterfly options strategy involves 4 options contracts (same type: all calls or all puts) with the same expiration date. You use 3 different strike prices: one in the middle (called the "body") and two at the outer ends (called the "wings").

  1. Buy 1 option at the lower strike price (wing).

  2. Sell 2 options at the middle strike price (body).

  3. Buy 1 option at the higher strike price (wing).

This strategy is used when you expect the underlying asset’s price to stay near the middle strike price (425 in our case) by expiration. Good for low volatility environment.

Max Profit: You achieve maximum profit if the stock price is exactly at the middle strike price at expiration. See the peak of the triangle in the above payoff profiles? That's your max profit - right exactly at the sell leg 425 Call.

Max Loss: Your maximum loss is limited to the net debit paid to open the spread.

Risk/Reward: Limited risk (cost of trade). Limited reward (difference between wing and body strikes minus the cost).

Breakeven Points:

You will break even if the price of the underlying asset is between:

Lower breakeven: lower wing strike + net premium paid.

Upper breakeven: higher wing strike - net premium paid.

Pros: This is a poor man strategy - sometimes called poor man spreads. Low-cost strategy due to selling two options. Limited risk and limited reward. But, the R: R is very high for November due to the theta being small and more credit collected at the center strike 425.

Cons: Profitable only if the stock stays near the middle strike price. Requires precise forecasting of price movement.

So, why we changed our view on Microsoft after 2 days, and closed this spread to open a Dec 20 425 Long Call? Let us look at the idea behavior as part of our initial plan A.PLAN A: We expected the stock to drop first to the 403 level, which it did only until 408. The plan is to end up near the 425 strikes and close in profits - we don't have to wait until expiry, although the strategy says so, as we have a risk from upcoming earnings that could move stock beyond or below the 425 level. We close options in profits similar to other credit and debit spreads before expiration. The more time it takes to come to the center of the triangle by dancing around or outside the wings, the better payoff we will have. In the performance profiles, you see that we have the maximum profit one day before expiry, where the dotted line matches with the bold triangle border. But, any day before that, the dotted curve/line will stay below the triangle. So, this position gives us immense profits as time passes with low risk. This means that despite this being a debit position in options, we actually benefit from the Theta (time decay). This is why we call it a poor man spread because theta works in the favor of the option buyer here. We intended to exit on October 22nd, as you can see in the profiles above. We thought when the price goes to 403 and then bounces off from there back into our wings of the butterfly - the profit that day would've been higher than when we closed it. So, PLAN A failed as the price didn't fall much and actually bounced off with another buy signal coming up in our models and respecting the triangle constraint at the lower bound, as shown in the chart above. Had it fallen to our level of 403, which is actually a very strong support level, we could have sold a Bull Put Spread and captured theta decay and the price rise from there afterward.

In our Butterflies above: we want the stock to take all the time it wants and come into the wings slowly towards the body at 425 Call. But it seems to come back faster than that with a lot of institutional buying happening at the support level when we pulled down the order tape. Even open interest in options is rising for the calls. So, it is clear that Plan A won't work. So we closed the position at a tiny profit.

So, what is PLAN B?

Plan B is to close the initial exposure in Microsoft and buy more time and calls. Remember that this position is actually correlated with our ES Bull Put Spread on E-Mini S&P 500 futures. The S&P500 has dedicated weightage for Microsoft at about 6.34%, with NVDA at 6.72% and most weighted Apple at 7.06%. So, these stocks actually contribute to the SPX movements in a bigger way than the rest of the stock market. You can see this in your overall portfolio beta and weighted beta in your broker's terminal. See how adding the position suddenly increases the overall beta of your portfolio.

Will the Plan B work? Well, it should, seeing our bullish case made with 5 points above.

What is the exit strategy? Just wait until earnings and exit before in profits - our calls won't lose much value due to increased implied volatility around earnings. Exit targets are neatly given in the resistance levels above.

How did we come up with those levels? There is a lot of analysis, but for starters, just focus on the Fibonacci Extension Levels explained above, joining the A, B, C & D points. Point D is where the 100% extension level is neatly respected. Typically, this is the level where the institutions will book profits and offload positions. That is why you see a sudden fall from there. Volume profile clearly distinguishes this between institutional activity and the retail's.

Now that you have learned about the Butterfly Spread and why we closed it and shifted our focus to Plan B, it is time to patiently wait for the manifestation of our plan.

Checkout this beautiful explanation from Tasty Live, our US broker's Knowledge Base.

Check the levels written above for boundary points where the stock may react.

Strategy

• Catalysts: Earnings on October 30th, 2024 for Q3 performance.

• Risk Factors: Nothing major. Max risk was already taken care of in Long Call.

• Correlation: Very much applicable. Watch your overall exposure you are adding/cutting to the S&P 500 through ES Bull Put spread or any of the index giants explained above.

• Portfolio Exposure: This trade adds a positive exposure to the tech sector weightage and increases the beta along the ES Bull Put Spread that is currently open. Fetches increased overall portfolio exposure at the time of writing this brief.

• Maximum Risk: 1-5% of the total portfolio capital. No deviation!

• Hedging Strategy (if applicable): NA.

  
  

Economic Events

Oct 17: Retail Sales & Unemployment Claims

• Impact: This may cause slight volatility in US equities ahead, but nothing major to worry about.

Oct 11 & 12: Inflation numbers CPI & PPI

• Impact: The event already passed at the time of writing this brief, but indeed pinned the market down a bit. Should recover soon next week if there are no retailation attempts from Israel in the near term.

Summary

We intend to give it ample time and exit before the earnings results. If you are comfortable, you may try waiting further into the expiry or November in anticipation of this stock being exploded to upwards as it approaches the end of the tip of the triangle. If profit appears, we may exit on demand as usual, at which point in time, you will receive an email alert for the trade closed or adjusted.

Closing Notes

This trade is valid only as long as the price doesn't move 3% - typically for a day or two. It is even available at a cheaper price now as well. Don't consider the trade if the stock has moved beyond the exit levels mentioned above.