Considering Our Options – $HLF – Senator Smokes Herb

by CC January 23, 2014 11:15 am • Commentary

Herbalife got a tape bomb this morning in the form of some initial congressional investigations into their business practices:

(Reuters) – Massachusetts Senator Edward Markey is asking for more information about the business practices of nutrition company Herbalife, which has been accused of running a pyramid scheme by prominent hedge fund manager William Ackman.

Markey sent letters to the Securities and Exchange Commission, the Federal Trade Commission and to Herbalife itself to try an obtain more information, his office said in a news release on Thursday.

This has been Ackman’s point all along and the reason we recently highlighted some big options activity (Big Options Activity Looking for Herb to Get Smoked) as well as placing a bet on a change in fortunes in the stock sometime in the near future (New Trade $HLF: A Small Hit of Herb)

So now that the stock is down on this headline, let’s look at our position and consider what our options are here. To recap, here’s the trade from Friday:

TRADE: Bought the HLF ($71.10) Feb 70/60/50 Put Butterfly for $1.50

– Bought 1 Feb 70 Put for $7.05

– Sold 2 Feb 60 Puts at $3.72 each ($7.44 total)

– Bought 1 Feb 50 Put for $ 1.89

With the stock around $64, this structure is worth about 2.20 but that could change quickly if the stock settles in here or keeps melting a little lower. Right now, the trade is intrinsically worth about 6 dollars. That means that there is nearly 4 dollars of extrinsic premium that has not been realized in the structure. Obviously with about a month to go until expiration, you would expect a difference between extrinsic and intrinsic but in this case it’s pretty massive. Why is that? Vol.

February volatility has spike higher by about 20 points today. What that means for an in-the-money butterfly is a worse mark to market price vs the intrinsic value of the structure. If the stock was outside the wings of the trade (below 50 or above 70) the increased volatility would actually be helping the structure keeps it’s value. But in this case, with 60 as the sweet spot and the stock very close, it’s hurting.

So a couple things can happen to start to get that intrinsic value. The stock could creep lower towards the sweet spot, as anything close to 60 is the best possible spot for the trade, all other things being equal. The other thing that can happen is the stock settles a little and February vol comes in a little.

So we’ll stay in this trade even after the initial headlines as we have it right where we want it. We’ll be keeping our eye on vol and the headlines and look to take this off at a more opportune time.