Microsoft (MSFT) Slides Ahead of Earnings

After trading in a relatively wide but elevated range for the last quarter, the share price of Microsoft Corporation (MSFT) has recently broken out to the downside ahead of the company's fiscal second quarter earnings results. The Microsoft share price has recently fallen to the bottom of a zone that is relatively thin on buying volume. Analysts are forecasting the company to report $2.32 in earnings per share (EPS) in addition to $50.78 in revenue. This represents a 40% expected increase in profit and 26% expected increase in revenue on a year-over-year basis.

The technology sector has underperformed the market of late, as investors appear to be seeking stocks that are better positioned to succeed in a market environment of increasing interest rates. The sector itself appears to be in correction territory, and Microsoft stock itself has fallen over 13% over the past month.

Option traders appear to be taking positions implying that they think the recent downturn for the Microsoft share price could continue in the near term. That's because the open interest for Microsoft seems to illustrate that traders are buying puts while selling calls. The stock is also threatening to break through a zone typically marked by heaving selling volume to the downside.

This comes in contrast to a raft of recent analyst reports that forecast a positive outlook for the Microsoft earnings report. Analysts will be looking for growth in the cloud business segment for Microsoft and appeared to be bullish on the company's recent acquisition of gaming company Activision Blizzard, Inc. (ATVI).

Recent Sector Performance

Microsoft represents more than 20% of State Street's Technology Sector ETF (XLK) holdings by percentage. The sector recently has been one of the major laggards of the market at large. Over the past month, XLK has slid 12.6%, compared to an 8.2% decline from the S&P 500 (SPX). The chart below compares the recent performance of Microsoft and XLK with nine of the top sectors of State Street’s S&P 500 Index ETF (SPY).

It's notable on this chart that sector rotation appears to show that investors are positioning themselves to be prepared for more hawkish policy from the Federal Reserve, including the increase of interest rates to combat inflation. The top performing sectors—energy (XLE), consumer staples (XLP), and financials (XLF)—are considered relatively "safer" bets during times of increased regulatory pressure. That's because these sectors reflect needs and necessities, rather than wants or speculative growth.

The worst performing stocks—technology (XLK) and consumer discretionary (XLY)—typically underperform during times of high inflation. Rising interest rates can put a drag on technology stocks because of their large amounts of debt, while consumer discretionary falls due to the assumption that consumer buying power will diminish as the focus shifts to "needs" over "wants." This sector rotation could be traders and investors anticipating the next state of the economic cycle.

Breaking Down the Technology Sector

The technology sector itself is the category of stocks relating to the research, development, or distribution of technologically based goods and services. This sector contains businesses revolving around the manufacturing of electronics, creation of software, computers, or products and services relating to information technology.

The technology sector is considered a riskier investment in an economy with rising interest rates because companies in this sector tend to have large amounts of debt, which becomes more expensive to hold as rates rise. Companies in the technology sector tend to be based on speculative growth, and a high cost of entry of these nonessential goods for consumers could lead to less spending by consumers in this sector.

The chart below compares the recent performance of Microsoft with the top holdings of State Street's Technology Sector ETF (XLK).

This chart helps illustrate how—over the past month, and specifically since the start of 2022—individual stocks in the sector have been trending lower. In fact, each of the top 10 holdings of XLK has trended lower, with Intel Corporation (INTC) posting the slimmest lost, falling 2.2%.

Microsoft finds itself in the bottom half of performers based on this chart. This is notable because Microsoft accounts for more than 21% of XLK holdings, which means that the performance of Microsoft and XLK are closely tied together.

Volume Profile

Comparing price action and option trading can provide chart watchers insight into the sentiment traders and investors hold toward a company's future performance. However, further context of price action in terms of volume could illustrate areas of support and resistance, which could provide additional context to option open interest. The chart below illustrates the recent price action of Microsoft, in addition to a price-based volume pattern on the left side.

This price-based volume pattern depicts the prices where investors have bought and sold the shares previously. A noticeable amount of buying in the past often implies that investors will feel the desire to defend their positions at those same prices by buying more shares or at least not selling any further. When volumes at a given price are low or nonexistent, it implies that few, if any, investors have the need to defend their positions at these levels.

A notable thin volume zone appears at and above the most recent Microsoft closing price. The area in which volume appears the heaviest, which is the top third of the most recent trading range, is known as the point of control. This identifies the price level where most trades took place. For Microsoft, the point of control appears on the chart around the $335 price level. The point of control represents 13% upside to the current share price of Microsoft.

The Microsoft share price recently closed near the bottom of a thin zone of bearish volume, highlighted by the red rectangle. From underneath this zone, it would have acted as resistance. The Microsoft share price appears as if it could move below this level, and it would then have a difficult time moving back above this point. This will be a significant price area for Microsoft ahead of earnings and could shape how option traders position their bets.

Options Look

While Microsoft has recently broken out to the downside, it appears that option traders are positioning themselves for the share price to continue to fall in the future. Recent trading volumes only slightly favored calls over puts, and the open interest features 1.2 million calls compared to 1 million puts. While at first look these open interest figures appear bullish, additional analysis illuminates further details.

For Jan. 28, the next weekly expiration date for options, it appears option traders are placing significant bearish bets on Microsoft. That's because, for options at the money and one strike either direction, puts outnumber calls more than 2-to-1. The highest open interest for call options appears at the $320 strike, with 12,600. This represents 8% upside to the current share price of Microsoft and is well above the recent thin zone of buying on the volume profile chart.

This 8% upside for the $320 calls is significant, as option pricing, based on the at-the-money straddle pricing, is predicting a 6.2% move up or down for the Microsoft share price this week. Implied volatility for the $320 call also appears to be falling while open interest is rising, which could mean that option traders are selling positions in this option ahead of earnings.

Ahead of earnings, implied volatility tends to be at its highest. This creates an environment that is beneficial, yet risky, to option sellers attempting to capture volatility decay after a stock reports earnings. While implied volatility is rising, the skew of this volatility is very bearish. Implied volatility skew shows the market's bias for pricing in volatility risk to the option premium of downside puts and upside calls. If the implied volatility for downside puts is increasing relative to upside calls, then that suggests the market is pricing in for a larger fear of a downside move. Current skew is trending higher, which translates to a bearish outlook for Microsoft stock.

Wrapping Up

As one of the bellwether technology stocks, investors will be watching Microsoft earnings closely. Microsoft has lagged the underperforming technology sector, while call and put open interest appears to be positioned for the share price to continue to fall in the near term.