MANIC MARKET MUSING #1 for 2013 - HERBALIFE

PERSHING SQUARE / HERBALIFE SMACKDOWN CREATES EXTREME STOCK PRICE VOLATILITY – AND TRADING OPPORTUNITIES

ANATOMY OF A RISK-REVERSAL OPTIONS TRADE IN HERBALIFE (HLF)

Bill Ackman’s very public assault on Herbalife (HLF) caused a panic selloff, resulting in an almost 50% drop in HLF’s stock price over the course of just a few days.  In addition to the massive apparent gains for short sellers like Ackman (and possibly David Einhorn) and massive losses and panic for HLF longs, many traders, myself included, sensed a new potential trading opportunity.

Regardless of what you think of Ackman’s “its going to zero” presentation and declaration, there are short and long opportunities in HLF that can, did and will present themselves over the days, weeks, and likely month to come.

I had never traded HLF before and knew little about the company.  Thanks to Ackman, the media, and other traders & investors, some of whom I interact with regularly , I know quite a bit more today – but not enough to know what will happen from current price levels (HLF was around $28.25 as I began to write this, it closed at $37 on Jan. 4).

chart courtesy of  http://seekingalpha.com/article/1094381-herbalife-gains-a-big-friend-in-robert-chapman-as-bullish-momentum-rises Dr. Duru

My initial assessment of the HLF situation was that the magnitude of the HLF sell off, exacerbated by year-end tax issues, was likely overdone, Ackman may or may not have been covering, the Company is highly likely to aggressively fight back (assuming it can fight back - we shall see on Jan. 10), a reversal and/or short squeeze is reasonably likely sometime after year-end (check).  These factors suggested to me that Herbalife presented a potentially potent swing long opportunity. 

As a result, I decided to establish a long biased position, through options, that would not tie up much of my trading capital and limit my risk.  I started doing this at around $25 / share last week.  If I do this right, and the market and the stock cooperates, I could very quickly create a “free” and ultimately very profitable options trade without taking on too much risk.

Since getting involved, the saga has only gotten more interesting and dynamic.  Bill Ackman has his $1B short, or so he says (did he cover any ? we do not know.).  Whitney Tilson announced at the bottom “me too”, that he was short (many snarks took that as a sign of the bottom being in).  On the long side, Robert Chapman of Chapman Capital weighed in with a claim of putting 35% of his fund long HLF in the $20’s, and John Hempton of Bronte Capital publicly trashed Ackman with a blog post and TV appearance on Ackman’s “truly awful short thesis”  (see http://brontecapital.blogspot.com/2013/01/ackmans-herbalife-thesis-someone-from.html )

Here is where this particular trade stands today in one of my trading accounts – hopefully  you can follow along:

December 24

Buy 5 May1913        $30 call           $4.79   debit              ( $ 2,395.14)

Sell 5 Dec28               $30 call           $0.59   credit                $    294.85

Sell  4 Dec28              $27.50 put     $3.10  credit                 $ 1,239.86  

December 26

Sell  5 Jan1913          $15 put           $0.60  credit                  $  299.85

Sell 2  Jan1913          $32.50 call     $1.95  credit                  $  389.94

December 27

Sell 3  Jan1913          $30 call           $2.45   credit                 $  734.90

Buy 5 Dec28               $30 call           $0.15   debit                 $    (75.14 )

December 28

Sell  3 Jan1913          $22.50 put     $0.70  credit                 $   209.91

December 31

Sell  5 Jan1913          $47.50 call     $0.10  credit                 $     49.85

NET CASH PROCEEDS (COST) =  $ 748.88

My Current Position as of January 4, 2013

Long 5 May 30 calls

Short 2 Jan 32.50 calls

Short 3 Jan 30 calls

Short 5 Jan 15 puts

Short 3 Jan 22.50 puts

Short 5 Jan 47.50 calls

LONG OPPORTUNITY: 

I CAN KEEP WRITING / ROLLING FULLY HEDGED SHORT CALLS THROUGH MAY EXPIRATION - TAKING IN ADDITIONAL PREMIUMS (CASH) AT EACH STEP ALONG THE WAY.  The amount of proceeds that can be generated will vary depending on where HLF trades at the time I decide to roll.

RISKS:

If Hebralife trades to new lows from here between now and January monthly expiration (below $22.50), I may have to buy up to $14,250 in HLF shares that could have a value less than that amount (300 shares @  $22.50, and 500 shares at $15).  However, that seems unlikely now, and there are numerous ways for me to protect against that risk (hedge, buy back the puts, roll them out and/or lower for credits for example); and depending on the price performance of HLF, I can roll put options again and again for additional premiums, or simply let these short put positions expire, and the downside risk will expire with them.  My risk / reward posture to the downside is contained and for me represents an acceptable level of risk -  given my current assessment of the ongoing saga.

I also have some risk if HLF trades above $47.60 by January 19 options expiration (I view this as unlikely).   Above 47.60, I start to give back profits and around $50 per share I could lose money – if I take no other actions.   I have strategies at the ready in the event these levels come into play.

Please note the following:

     1. This trade is a work in progress.  I will likely continue to stay in this trade, with additional option purchases, sales and adjustments for months to come.  At the moment, my trade is “free” (it has actually paid me net cash) although I do have some risk to the downside if HLF were to fall to new lows. I also have some risk to the upside in the event of an extreme and fast, and there are margin requirements on my short put positions.

       2.  There are risks that I took, especially initially, are ones that I am comfortable with within the context of my trading strategies.  Some of these are not for everyone, namely the sale of naked puts at certain price levels to bring in additional cash to help pay for the initial long trade.  Only sophisticated traders with large enough accounts and margin capacity that understand fully the risks involved should consider this type of put sale.  I could reduce the risk by adding spread protection, and still might do so, but I do not at this juncture see the need to do so.

  

       3. In particular, the short put trade at the $27.50 weekly strike for a $3.20 per contract credit.  This created a risk to me of getting long HLF at a net cost of $24.40, which I decided at the time was a reasonable risk to take.  If HLF kept (or keeps) falling, my perspective on risk may change.  This trade, however, turned out to be a 100% winner, as the puts expired worthless on Dec. 28.  This was key to my trade as it provided the backdrop for a “free” long trade and further gains.

    4.  Because of my unfamiliarity with Herbalife, I determined to keep the size of this trade small, at least initially.   If Herbalife was a “go to” name for me, I might have gotten involved in a larger way.  In hindsight, given the 50% + up move in the stock, a more aggressive long posture would have been warranted, and would have been highly profitable.  In this case, I decided to play small due to my being new to the name, which was also a measure of risk control.   

      5. I expect that when this trade is over, that my profit could easily be in the $3,000-5000 range (remember, I have 4 months of additional fully hedged option sales ahead of me).  Overall this is a very small trade for me, but is one I make to a) be involved in a high profile, dynamic situation with minimal risk, and b) to further test and hone my options strategies for these type of situations and hopefully profit nicely while doing so.  

          

          Comments are welcome -- @CapCube

     Disclaimer:  This post is for educational purposes only and is not to be construed as trading advice.  The author currently has trading positions in HLF as described above and other positions that are not the subject of this blog post.  Any and all positions are subject to change at any time and will not likely be the subject of public discussion.