/Microsoft%20sign%20at%20the%20headquarters%20by%20VDB%20Photos%20via%20Shutterstock.jpg)
Heavy trading in Microsoft out-of-the-money (OTM) call options today highlights investors' views that MSFT stock is undervalued. Based on its free cash flow and FCF margins, MSFT could be worth much more.
Microsoft is at $428.69 in morning trading on Wed., Oct. 23, up from recent lows of $409.54 on Oct. 7 and $401.70 on Sept. 6. Moreover, the stock hit a quarterly low of $395.15 on Aug. 5, shortly after releasing its Q2 results on July 30.
Microsoft is due to report its upcoming results for its FY 2025 Q1 on Oct. 30. So, is MSFT due for another fall just like last quarter?
After all, it produced excellent results, as I pointed out in my Aug. 2 Barchart article, “Microsoft's Quarterly Free Cash Flow Rose - MSFT Stock Looks Cheap Here.”
MSFT Stock is Undervalued
At the time, MSFT was at $406.20. Based on its strong free cash flow and FCF margins, I argued that it was worth 21% more at $495 per share. Analysts tend to agree with me.
For example, Yahoo! Finance reports that the average analyst price target is $495.97, and Barchart's mean survey price is higher at $503.24 per share. Moreover, AnaChart, a site that tracks analysts' price targets as if they are stocks, shows that the average of 38 analysts is $481.86.
That represents a potential upside in 12.4% in MSFT stock over the next year.
That could be why there is a large volume of out-of-the-money (OTM) call options trading today. That will be well after Microsoft reports quarterly results for its fiscal Q2 ending Dec. 31.
Unusual Call Options Activity
This can be seen in Barchart's Unusual Stock Options Activity Report (see below) today. It shows that over 25,000 call options contracts have traded for the expiration period ending on Feb 21, 2025. That is 121 days from today or just about 4 months from now.
It also represents over 65 times the number of call options contracts that were outstanding before today's activity. Let's look into what is going on here.
MSFT Calls expiring Feb 21, 2025 - Barchart Unusual Stock Options Activity Report - Oct. 23, 2024
The strike price is $470, over $41 higher than today's price, or 9.65% higher than today's price of $428.63. That means the strike price is out-of-the-money, i.e., it has no intrinsic value unless the stock rises significantly before the expiration.
Nevertheless, the options price is $11.20 at the midprice - all of which is extrinsic value. It means that the call option buyers are very enthusiastic about the possibility of MSFT rising over the next year - or at least over the next 4 months.
The reason this works is simple. If MSFT is worth $495 per share, and the stock rises to this level, the call option will have an intrinsic value of $25.00 (i.e., $405-$470 strike price). That is 123% higher than the premium of $11.20 for the call option.
Moreover, the call option will likely pick up substantial amounts of extrinsic value over the next four months if MSFT keeps rising. That could also push up the premium of the calls over $11.20, regardless of whether there is any intrinsic value in the calls. In other words, this could be a speculative play.
Shorting Calls Works As Well
However, short sellers of these calls, especially covered call investors, can make a very good yield here. For example, the bid price of $11.15 represents 2.60% on today's trading price, or about 0.65% per month for the next four months.
Moreover, if MSFT rises to $470, the covered call investor could make a good profit. That represents a total return of 12.2% over today's price (i.e., $481.15/$428.63-1). This includes the price gain from $428.63 to $470.00 plus the $11.15 income received today from shorting these calls.
In effect, this is also a bullish play on MSFT stock over the next four months.
The bottom line is that today's large volume in MSFT call options represents a bullish outlook on MSFT stock. These investors believe that Microsoft will report excellent earnings and free cash flow over the next several quarters.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
