Option players bet on limited volatility in Microsoft (NASDAQ: MSFT)

During Monday’s session, Microsoft (NASDAQ: MSFT) shares bounced back slightly along with the broader market. By the close, shares of the software giant were up 0.8% to $28.41. Implied volatility drifted lower during the session, as the 28-strike straddle in February was priced at $1.33 at the close, compared with Friday’s closing price of $1.51.

In the options pits, we noticed action on both the July 27 puts and July 30 calls. With MSFT trading at $28.41, both of these options are out-of-the-money. More than 30,000 contracts traded on both the put and the call, which came into the session with respective open interest of 4,800 and 26,683 contracts. This morning, the July 27 put is home to more than 32,500 contracts while the July 30 call has open interest of more than 57,000. In other words, the lion’s share of yesterday’s volume traded to open.

At 12:48 PM Eastern Time on Monday, a massive block of 25,598 contracts traded at the put strike, going off for $1.55 per contract (and making the entire block worth almost $4 million). At the end of the day, the put was down 24 cents with the stock up 23 cents. The fact that the put moved more dramatically than the underlying was indicative of falling implied volatility, which is generally brought on by selling pressure.

Meanwhile on the call side, the same-sized block (25,598 contracts) changed hands at the July 30 strike at 12:48, trading for $1.17. This call gained just two cents on the day despite a 23-cent gain in the shares, indicating that these options were also sold to open.

It is very likely that this was a short strangle strategy, initiated by investors who expect limited volatility from MSFT for the next several months. The trader will book the maximum profit (the combined $2.72 per spread collected) if MSFT is trading between the sold strikes (27 and 30) at July options expiration on July 16th. Between now and then are third-quarter earnings in late April. The breakeven points for this strategy are $24.28 to the downside and $32.72 to the upside, a range of roughly 35%.

The harsh reality of short strangles is the unlimited risk potential. If Microsoft rallies above $32.72, losses are theoretically unlimited for the strangle seller, who has the obligation to sell the stock at $30. Additionally, if the stock drops through the $24.28 mark, losses to the downside are limited only by the zero mark, as the strangle seller has the obligation to buy the stock at $27.

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