The war between Carl Icahn and Bill Ackman over Herbalife has been heating up, and so far Icahn is coming out on top. It's recently been disclosed that Icahn's deploying an option strategy to increase his long leverage for less money, and it's pretty aggressive. It also reminds me of a similar situation I was in back in 1998.
What Icahn is doing is going long HLF calls (which is a long position, for all intents and purposes) and he's granting HLF puts (which is a short put position - aka a really aggressive long position in the stock). This kind of strategy is great when you're right; not only is buying calls cheaper than buying the stock outright, but granting puts brings in premium which further lowers (or even eliminates) the cost of the calls. It sucks when you're wrong, though, because then you lose on both sides of the trade.
Anyway, back in late April or early May of 1998, the annual short coffee trade was lining up. Don't ask me why this trade works each year, it just always does. But this year in particular, the options premiums on coffee were all out of whack.
Now you have to understand that I worked for a pretty plain vanilla commodities firm. And by plain vanilla I mean they'd hire pretty much anyone who could pass the Series 3 and brokers were more or less restricted to long option strategies. And this was a good thing because they weren't the brightest group of guys overall, if I'm being honest.
They weren't allowed to trade futures for clients (only futures options) and they were certainly never allowed to grant options. So research would tell us what they thought was going up or down and these guys would go buy puts or calls accordingly and hope for the best.
It never occurred to most of these guys to consider who might be on the other side of their trades. I remember asking a few of the brighter guys who they thought made all the money when their options expired worthless (which happened roughly 90% of the time). Most would shrug and assume that everyone lost everything. When I'd point out that the guy who sold them the options got to keep all the premium, I usually got a blank stare.
So everyone was pretty surprised the day Research pulled us into a meeting and advocated a short options trade. The crux of the trade was short coffee, and to that end Research was recommending that we buy July coffee puts and offset the cost by selling July coffee calls. The calls were deep out-the-money and were trading for a ridiculous premium for some reason. For me the trade was a no brainer.
After the meeting one of the top guys pulled me aside and asked me to explain the trade. I went through it once and he was still pretty confused.
Him: So, wait. We're buying puts and selling calls. So the calls protect the put position, right?
Me: No. In fact this is an unlimited risk trade if it goes against us.
Him: That can't be right. They'd never tell us to do that.
Me: Well, you should only do it if you think Coffee's gonna drop. If it does, you make money on the puts and the calls expire worthless.
Him: So then don't we lose all the money on the calls?
Me: No, because you wrote the calls. The guy who bought 'em from you loses all his money.
Him: But what if Coffee goes up?
Me: Then you're fucked.
Him: This doesn't make any sense. How can you be both long and short?
Me: You're not, dude. There's short, and then there's real fuckin' short. This is real fuckin' short.
Him: You're not seriously thinking about doing this, are you?
Me: You're Fuckin' A right I am. I'm going A to Z with this shit.
Him: No way, dude. I wouldn't touch this trade. You're crazy.
Long story short, the trade worked out and set me up for a dandy summer. And it's only fair to mention that my buddy's reluctance was due in no small part to the fact that we were all personally liable for any trading losses the client refused to cover. So if you buried a client for thirty or forty grand before you could cover and the client refused to pay, you'd be in a mell of a hess.
Anywho, it looks like Icahn has decided to get real fuckin' long on HLF, which is a shame because HLF is clearly a scam and probably should get shut down but won't. The damn thing almost hit $45 on Friday, so if anything all the bad press is having a positive effect on the stock price.
Go figure.
Nothing fucks harder than a negative gamma position on a stock that will go into freefall. I think going long is a mistake, but shorting options is suicidal.
In all fairness, short puts is a limited downside proposition. For example, if you write a $25 put, you know you'll never be out more than $2,500 on each one. Short calls is another story. That is truly unlimited downside.
That is an incredibly charitable view of HLF's business model. The fact that HLF produces anything is secondary to the fact that its success is predicated on continuous recruiting (aka Ponzi Scheme).
Tupperware is multi-level marketing, and more than 90% of their product is sold to outside consumers who aren't Tupperware distributors. More than 90% of Herbalife's sales are to its own distributor network. Clearly a scam.
Theoretical analaogy: if your firm requires you to trade on inside information, that's clearly illegal. If it's not firm policy but a lot of people are trading inside information because it's easier to make money that way, then as long as the management team isn't implicated and it's not a rule, the firm is in the clear, at least from a legal standpoint. The reputational damage from such a thing can kill a firm. And just like a trading shop, there's a ton of churn, these aren't typically sophisticated relationship people, they're the get rich quick type. That's the clearest way I can explain the way I see this.
At this point, my guess is that Ackman understands his mistake and is hoping the negative publicity will cause people to leave the company (again, not necessarily a bad thing) and therefore cause the stock price to collapse. But since Icahn's entry, and the HOLY F'ING HELL MASSIVE amount of koolade the HLFers drink, I think the company will be just fine and may even sue Ackman for slander. Depending on a number of things, Ackman could be looking at charges of manipulating the market (bogus, but easy publicity for DOJ or whatever).
If we can't agree to disagree, let's wager?
I'm thinking of building a website, finding some drop shippers and a few sales people (from Craigslist, of course) and using Ackman's Herbalife slides to help build a HLF knock-off. I wonder if Ackman would front me a few mill to help bolster his $1B wager.
LOL. We don't disagree at all. I wouldn't touch the short side of this trade with a ten foot pole. I just happen to think it's a Ponzi scheme. But the gov't needs Joe Sixpack to have access to dreams, no matter how foolhardy, and therefore they'll never touch HLF.
Wait a second, wait a second. If you buy a call and write a put, that isn't some sort of crazy thing. It's just a synthetic long position. Your returns, excepting transaction costs will very closely approximate a long position. The price you pay for the call will roughly cancel out your earnings on the put. You make money on the call when the underlying goes up and you lose money on the put when the underlying goes down. The end result is that, by buying the right quantity of stock you could get the same payout structure.
It's a way to build up a position without buying too much of the underlying instrument for whatever reason. Nothing makes it "real fuckin' long."
This. The difference is that this method enables him to scale much larger, since the upfront capital is much less than buying the stock outright.
Yup. We've done this before and it's just the same as owning the stock but with a higher trading cost offset by the value associated with not having to actually have a huge position in the stock and putting a huge piece of capital to work. Own a call at strike X and write a put at strike X, when stock is under strike X you're out on the put and capped but out on the call, stock goes above X and you're safe on the put premium and up on the call. Same payout structure just if you size it wrong I guess then you'd end up being real fuckin' long, haha...
I'm not touching either side of this trade. It currently hinges on government action (or inaction). And I never want my returns dependent on the arbitrary decisions of some elected official/judge. HLF is in the the pyramid-scheme gray-zone; it could go either way.
One of my personal rules is to avoid businesses where >33% of revenue comes from the government, or where a regulatory change could potentially break the business. I will only violate the above are in the case of large defense contractors (Lockheed isn't going anywhere), and when the expected value is high enough to provide a margin of safety even when incorporating the potential for a government crackdown (De Vry).
Why are you guys afraid of a short?
Good logic
Many people categorize every MLM as a pyramid scheme, and sure there's money to be made short term (read: johnson made 90mm last year); however, while Icahn won't say it, he's long just to spite Ackman. We all know it. He's only hoping someone will buy HLF, or the govt turns a blind eye. If you saw the earnings transcript of Lehman just before they went under, you know the party can come to an end real quick.
http://dealbreaker.com/2013/02/carl-icahn-wont-say-that-he-bought-herba…
[quote=BTbanker]Many people categorize every MLM as a pyramid scheme, and sure there's money to be made short term (read: johnson made 90mm last year); however, while Icahn won't say it, he's long just to spite Ackman. We all know it. He's only hoping someone will buy HLF, or the govt turns a blind eye. If you saw the earnings transcript of Lehman just before they went under, you know the party can come to an end real quick.
http://dealbreaker.com/2013/02/carl-icahn-wont-say-that-he-bought-herba…]
LOL. Yeah, I don't think anyone is long because they think it's a great company.
Great story, Eddie. Thanks for sharing. Didn't you do a full post on that coffee trade a while back?
Yeah, a couple years ago but now I can't find it. I was going to link to it in this post because May is right around the corner...
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