Name That Trade – I Didn’t Choose the $HLF, It Chose Me

by Dan April 6, 2015 3:33 pm • Commentary

Over the last 24 hours, CNBC’s Scott Wapner reported that Herbalife has been contacted by law enforcement agencies:

Federal law enforcement agencies recently contacted several Herbalife members for information about their own business practices

According to sources familiar with the matter, the inquiries came last week and focused on the activities of 10 or so mostly top Herbalife members.

It’s unclear exactly what law enforcement asked for, or the identities of the specific members in question.

Regular readers should be very familiar by now with the bull bear battle raging between the two billionaire hedge fund managers, Bill Ackman and Carl Icahn. Ackman, of Pershing Square, thinks the company is a pyramid scheme, will be shut down by regulators and the stock’s going to zero. He has a nearly $1 billion short bet against the stock.

Legendary activist investor Carl Icahn (who has five board seats with HLF), is the largest shareholder. He thinks the stock is massively undervalued and that the company’s business practices are on the up and up.  

While I don’t have any of my billions tied up in this trade, I side with Ackman that something (or somethings) are fishy. But have no dog in this hunt and am likely to remain that way until a better entry. Whatever part of the 50% short interest that is not Ackman has pretty itchy trigger fingers,  making short trades challenging. On the flip side the stock is always one tape-bomb away from being a hat size.  This is an adult swim, people.

Shortly after the open today, the stock was down a little more than 4%. It has since reversed and is now up 1% on the day.

Illustrating my point about how difficult this stock is to trade is the more than 50% move off of the 2015, and 2 year lows made in January:

[caption id="attachment_52506" align="aligncenter" width="600"]HLF 2yr chart from Bloomberg HLF 2yr chart from Bloomberg[/caption]

Options prices in HLF, despite being down handily from the highs made in January (30 day at the money implied vol was as high as 120%!) is still very high at 80%, making long premium directional trades very challenged.  But there are a couple scenarios where this high IV could be of benefit for those who are positioned long in the stock as Icahn is, or those looking for the stock to go to zero, as Ackman is.

Hypothetical Trades:

Bullish (Icahn):  

Against 100 shares of LONG stock $43.42 Buy Nov 55 / 65 1×2 call spread for even money

-Buy to open 1 Nov 55 call for 4.80

-Sell to open 2 Nov 65 calls at 2.40 each or 4.80 total

Break-Even on Nov Expiration:

Profits: Gains of stock above current levels and up to $65. Between $55 and $65 make up to $10. Stock called away at $65, but you have effectively sold at $75 when you add in the $10 profit from the overlay. Think about adding a 1×2 call spread to a long stock position as both yield and leverage at the same time.  You have bought one call, and sold one call, a call spread to add leverage and you have sold a second call which essentially serves as an overwrite of your long stock. But the trade structure has not cost you anything, and doing it for no cost has not resulted in additional risk on the long side. It is not a hedge in any way if the stock goes down.

Losses: If the stock goes lower than you only have the losses of your stock position.  There is one big caveat here, if the stock were to moved materially above $75 then you would have capped your gains.  But I would add the all time highs in the stock from early last year was $83.50 and given the earnings and sales declines from its peak last year given the company’s changes in selling and accounting I am hard pressed that the stock makes a new high anytime soon on merely its fundamentals.


Bearish (Ackman):  

Against 100 shares of SHORT stock Buy to open HLF ($43.55) Jan15 25/15 1×2 put spread for $1

-Buy to open 1 Jan15 25 put for $3

-Sell to open 2 Jan15 15 puts at $1 each or $2 total

Break-Even On Jan15 Expiration:

Profits: between $24 and $15 make up to $9 with max gain of $9 at $15.  At 15 or lower your short stock is called away, but you have effectively added $9 in leverage to your short, bringing you down to about $6 in the stock.

Losses: Above $24 you lose $1 in premium.

Rationale: to spend any premium on a leverage trade like this on the short side, you would have to be very convicted (like Ackman) that there is potential that the stock goes materially lower and probably not to zero. This trade is there for a collapse and only has any real risk if the stock goes to zero.