Schaeffer's Outside the Box Blog
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Happy Holidays, everybody. I hope no one got any shares of Herbalife Ltd. (NYSE:HLF) in their stockings. Or if you did, I hope it had a cost basis near the current quote.

In case you missed it, HLF got pounded last week. It was trading at $44 on Dec. 17, and was down to $26 by Dec. 24. That's thanks to Bill Ackman shorting the stock, getting a couple friends who we'll call "David" and "Jim" to go short it as well, and then talking it down big time so his shorts would work.

Okay … that's kind of the Herbalife CEO's version of the story. There's nothing wrong here, just a couple Sith-Lord types saying bad things about his wonderful, totally above-board company … and causing his own self-fulfilling meltdown.

Personally, I've only heard of Herbalife because I've seen their name on the LA Galaxy uniforms. And hey, they beat Seattle and their "XBox" shirts in the playoffs, so Herbalife must be a great company. Or not. The whole upselling business model they use sure sounds like it lends itself to manipulating profits as they see fit. But it's also far, far, far from my field. My strong inclination is to believe the shorts in a situation like this.

The CEO also threw out some options-related accusations, namely that some of the statements last week meshed all too nicely with options expiration. And HLF did see some big put action over the course of the cycle, though it's a bit of a chicken-and-egg sort of argument, if you look closely at the numbers.

Here's a look at the open interest numbers over the past month, and we can see two big spikes in put open interest. The first one occurred at the end of November, as it shot up from 67,000 to over 100,000 in a three-day span. And the second open-interest spike occurred on Wednesday and Thursday of last week, as it rose from 108,000 to 146,000. And those put buyers clearly loaded up on December puts, as the open interest went right back down after expiration.

Thing is though ... the news was already out as Ackman laid out his case, and the stock was tanking. So it's very tough to make the case that there was any sort of manipulation. Basically it reads like the world heard what Ackman had to say and backed up the put cart either because they believed him, or they believed in the momentum of a stock on expiration week. And there's something to be said for that latter part.

The most important thing to remember about an option is probably the simplest. It's a zero-sum game. For every option purchased, there's an option sold. When that transaction takes place very near expiration, there's precious little premium in that option, even if implied volatility explodes like it did in HLF. Thus, the option seller has no premium cushion if the trade goes bad.

Long story short, anyone selling December puts into the volatility spike and stock implosion in HLF got burned very quickly and either had to buy the puts back or try to short the stock. Either way, they added fuel to the selloff already in progress.

So yes, technically, the put buyers "caused" some part of the ugliness, but it's very tough to make the case they manipulated it.

Going forward … well … who knows? You have huge short interest in the stock and you still have enormous implied volatility and put ownership, so there's always the chance that side gets squeezed somewhere down the pike. But it's also possible (perhaps likely) that this stock is going to hit true wallpaper status. I'd probably go with defined-risk bearish plays into the sporadic squeezes.

Disclaimer: The views represented on this blog are those of the individual author's only, and do not necessarily represent the views of Schaeffer's Investment Research.


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