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Earlier in my career, I was a Director in a large Wall Street investment bank focused exclusively on pricing and structuring equity and equity-linked derivative securities. A short work week consisted of 80 hours, while longer ones regularly exceeded 100 hours. During that time I learned quite a bit about how large quant hedge funds make outsized returns by making smart derivative bets.

As I look at the recent put volume in Herbalife (HLF), it has become clear to me that one (or more) large funds are likely making a small fortune by doing a trade that is completely misunderstood by the wider market. In fact, as smaller, less informed speculators attempt to copycat a trade that they don't even understand, they are actually helping to line the pockets of the smart money who actually understands the trade.

The large volume in the puts of controversial Herbalife, following not long after a crushing commentary by notable short investor David Einhorn, has led many smaller investors to conclude that a "whale" in the pond (presumably Einhorn) is making a monumental short bet against Herbalife in anticipation of a cataclysmic drop in the share price. Einhorn had raised several probing questions about Herbalife on its conference call back in May causing the stock to plunge by 35% from $70.00 to $45.00, where it remains today.

Unfortunately for the smaller speculators who have recently been piling into what they think are copycat put trades, all indicators suggest there is almost certainly nothing "coming." A fairly simple technical analysis of what has been going on with the stock and the puts shows that, whoever he is, the "whale" is almost certainly SELLING puts against a short position in the stock serving as a hedge. By doing this, the whale is collecting millions of dollars in option premiums direct from the pockets of smaller speculators, while taking on virtually no risk.

Proof of this fact is illustrated in detail in several parts below, but can be summarized as follows:

  • With well over $50 million of Herbalife puts traded in just a few weeks, only a large mega fund would ever be able to commit this amount of capital if it were to be a "naked" put trade
  • Yet any fund with that amount of capital would quickly realize that the economics of buying these expensive puts (at a date far before expiration) are massively inferior to simply shorting a large amount of common stock. This is illustrated clearly below.
  • A fund with that much capital would simply short large amounts of the stock, rather than buying puts, which would actually get them "net short" at far lower (less desirable) prices.
  • Even with a $4 billion company such as Herbalife, if such massive volumes of puts were bought "naked," there would be an easily observable decline in the share price simply due to delta hedging that market makers must do when selling the puts.
  • Instead, the share price has only declined by a few percent over the past few weeks, which has been largely due to copycat short traders who are anticipating "something coming."
  • The whale is clearly SELLING these puts (which puts upward pressure on the share price due to market marker delta hedging) while simultaneously shorting common stock (putting downward pressure on the share price) as a hedge. The result has been a relatively stable share price considering the volume of puts being traded.
  • This is nothing complicated and is simply a large "covered put trade" which is just the inverse of the much more common (and more widely understood) "covered call trade."
  • The bet is slightly bearish / neutral in terms of what is expected for the share price of Herbalife going forward. It is definitely not an extreme bearish bet on Herbalife.

Looking at these points in detail requires several different pieces of analysis:

Part I - Evidence of delta hedging

During the month of November (with the exception of Thursday, November 29), average daily volume in Herbalife shares has been relatively consistent at roughly 1.5 million shares per day. During this time, the highest volume on the shares was 2.7 million shares on October 31, while the lowest was 350,000 shares on November 23. November 29, represents an obvious special case for the share price and will be addressed separately below.

Anyone watching the options activity (which seems to be quite a few people lately) will have noticed that on individual days there was often more than 10,000 put contracts traded on various November and December strikes. This equates to over 1 million shares per day of shares underlying the options. Open interest on Herbalife put options as of Thursday, November 29, stood at nearly 50,000 contracts, equivalent to 5 million shares of Herbalife.

Strike

Price

Change

Bid

Ask

Volume

Open Int

Delta

$27.50

$0.10

-$0.15

$0.05

$0.20

197

1,255

0.03

$30.00

$0.45

-$0.02

$0.10

$0.30

203

956

0.04

$32.50

$0.25

-$0.56

$0.20

$0.40

3,595

2,422

0.06

$35.00

$0.35

-$0.83

$0.35

$0.55

2,734

3,780

0.10

$37.50

$0.65

-$0.94

$0.60

$0.75

5,879

3,971

0.16

$40.00

$1.10

-$1.05

$1.00

$1.20

12,198

9,911

0.27

$42.50

$1.71

-$1.09

$1.60

$1.90

10,067

6,845

0.38

$45.00

$2.74

-$1.26

$2.65

$2.95

5,925

9,018

0.53

$47.50

$3.80

-$1.25

$3.90

$4.40

9,099

10,342

0.68

Total:

49,897

48,500

Different strikes and maturities on the options have different "deltas." Delta represents the sensitivity of the option price to any move in the underlying share price. It also (therefore) represents the "hedge ratio," which market makers use when selling these options. For example, when the delta of the option is 0.70, a market maker would be required to sell 0.70 shares for every share underlying the put options that he is selling in order to maintain an effective theoretical hedge.

The further out-of-the money the options are (i.e. the lower the strike price), the lower the delta. At the time of the large trades on the $47.50 December puts a few weeks back, the delta was around 0.70, while the delta on the $40.00 puts was around 0.20. The lower strike puts have very low deltas and fewer contracts being traded, so these are less influential.

If we assume that the overall, average delta for the larger put trades was around 0.40, then a trade of 10,000 naked put contracts (which covers 1 million underlying shares) would imply that market makers would need to be shorting 400,000 shares that day, or about 27% of the average daily volume on any given day. And in fact, on the lighter volume days for the stock this percentage becomes substantially higher.

Yet as shown below, over the past month, the most that the stock has ever moved on a single day was a 5% decline, which occurred only once on November 2. In more recent weeks, the stock had typically only moved by no more than about +/- 2% per day, which is clearly not indicative of a large naked short bet against the stock.

Instead, what we have likely seen is that the whale has been SELLING large amounts of put options (which actually puts upward pressure on the share price) while hedging this trade by selling common stock (putting downward pressure on the stock). The net effect has been that the stock has actually been quite flat during the month of November, trading down just 8% since November 2, despite the perceived epic short bet against the company.

For the sake of completeness, the November share price activity is presented as follows:

Date

Closing price

% change

Volume

28-Nov

$45.00

-3.2%

2,575,996

27-Nov

$46.50

-2.5%

1,742,850

26-Nov

$47.68

-1.7%

1,036,809

23-Nov

$48.49

-0.4%

358,991

21-Nov

$48.67

3.0%

1,356,163

20-Nov

$47.26

1.6%

2,286,363

19-Nov

$46.50

3.3%

2,315,440

16-Nov

$45.01

-1.3%

2,504,957

15-Nov

$45.61

-0.3%

1,046,754

14-Nov

$45.75

-1.2%

1,250,729

13-Nov

$46.29

0.0%

1,258,742

12-Nov

$46.27

0.0%

916,547

9-Nov

$46.26

0.2%

1,580,376

8-Nov

$46.15

-2.3%

1,109,006

7-Nov

$47.25

-1.6%

1,115,233

6-Nov

$48.04

-0.8%

1,169,083

5-Nov

$48.41

-1.0%

1,330,179

2-Nov

$48.92

-5.2%

1,608,033

1-Nov

$51.58

1,831,933

Average

$47.14

-0.7%

1,494,431

Min

$45.00

-5.2%

358,991

Max

$51.58

3.3%

2,575,996

Part II - What happened on November 29?

For the first time in a month, Herbalife stock had a notably negative day on Thursday, November 29. The stock fell as much as 6% intraday and on much higher volume of 7.7 million shares, briefly hitting a new 52-week low.

As the share price started coming off, my phone starting ringing and my inbox starting filling up. The rumor in the market was that the much anticipated "event" for Herbalife stock was upon us and that the messenger was going to be Citron Research rather than David Einhorn. The rumor of the Citron report even showed up on the newswires; however, a Citron spokesperson declined to comment.

Short sellers certainly have a very clear memory of the effect that a recent Citron report had on shares of Questcor (NASDAQ:QCOR), and were no doubt hoping for a similar play on Herbalife. On Tuesday, September 18, QCOR shares closed at $50.52. The next day, Citron published a "smoking gun" report that certainly did not disappoint followers, sending the shares to a low of $22.26, a drop of 55%. The shares closed the day at $26.36, and over the subsequent few weeks they fell as low as $17.83, down 64% from the time of Citron's report. Since that time, the shares have recovered slightly, to around $27.00.

As it pertains to Herbalife, attentive investors will remember that on Tuesday, September 18, (just one day before the Citron report on QCOR), a very large trade on short dated out of the money puts occurred on QCOR. When I say "large" and "short dated" I mean that someone placed a bet of $5 million on out of the money puts, which would expire worthless just 3 days later if there wasn't a massive drop in the stock. When the stock experienced its epic drop, these options quickly increased in value by 30-50x. The stock dropped so quickly after the report that there was simply no time to sell these options fast enough, but even if we assume that sensible limit orders had been put in, it is very safe to assume that the profit on these options easily exceeded $100 million in a single day, or a return of about 20x. And obviously this excludes any profit that a short seller would have likely made on a substantial short position on common stock. It was a profitable day and no doubt someone will be having a Merry Christmas this year (or perhaps a Happy Hanukkah as the case may be).

With QCOR, the "smoking gun" underlying the report was actually very public information available to anyone with the tenacity to find it. In addition to other findings and analysis by Citron, the key piece of information was news of a reduction in payment coverage for QCOR's drug Acthar by insurance provider Aetna (NYSE:AET). As it turns out, this information had been publicly posted on Aetna's website for five days prior to the Citron report, so it came as a painful after-the-fact realization for many investors that they too could have placed an identical mega trade and made a small (or large) fortune had they only shared Citron's persistence in searching for relevant information. The implications of the Aetna news on the share price of QCOR should have been patently obvious to anyone who saw it, as evidenced by the massive share price drop, which occurred after Citron simply brought it to light.

As the rumors of an impending Citron report swirled around Herbalife on Thursday, the share price began dropping on volume and obvious naked put buying picked up substantially. As shown above, nearly 50,000 put contracts traded on Thursday alone, equivalent to 5 million shares.

However, early in the day Citron released a report on Usana Health Services (NYSE:USNA) instead of the anticipated Herbalife. The misperception that this would be an Herbalife report is somewhat understandable, given that, similar to Herbalife, Usana is a "direct selling" multi-level marketing (MLM) company that markets "nutritional and personal care products." This latest Citron report continues on a trend from Citron in exposing MLM companies such as Nu Skin (NYSE:NUS) and its operations in China. China has very strict laws against most MLM marketing practices, however both Nu Skin and Usana claim to be in compliance.

In any event, once the market realized that Citron was writing about an entirely different MLM company, shares of Herbalife quickly rebounded as the shorts realized they had guessed wrong. The upward pressure was further reinforced by the announcement from Herbalife that its COO had recently purchased over 45,000 shares of the company, worth over $2 million. So if "something is coming," clearly Herbalife's COO is not aware of it. And by the end of the day, Herbalife had actually risen by more than 3% in the after market, more than recovering from its earlier drop of as much as 6%.

Part III - the economics of buying puts is inferior to shorting common stock unless the buyer buys them close to expiration and has a clear view on timing of a share price move

Anyone who eyed the massive QCOR put trade witnessed the miracle of massive leverage that options provide, as well as the ability to make mind-boggling profits in a short period of time. However, it should be kept in mind that "time is the enemy of the options buyer and the friend of the options seller." For these trades to work, the options must be purchased very shortly before expirations (minimizing the price paid) and must be held for a very short period of time (minimizing the "theta" time decay).

In short, if you don't have certainty on timing, options are typically a very inferior way to bet on a stock price.

The fact that these Herbalife put trades have been going on for several weeks now illustrates the fact that someone is more likely selling them in size rather than buying them in size.

As speculators eyed what they perceived as a mega trade going on, I came across a number of comments, which observed that "whoever is buying these puts is losing $100,000 per day just due to theta (time value) decay alone, so they absolutely must know that something big is coming."

In fact, if we flip our assumptions about the whale upside down, we can see that the whale was actually making a profit of $100,000 per day in theta by selling these options, most likely against a large short position in the common stock as a very sensible hedge as a hedge.

Looking at the economics of a naked put trade vs. shorting common stock essentially proves this to be the case and shows that anyone with the capital to undertake such a large put trade would, with 100% certainty, prefer to short a large amount of common stock rather than buy puts.

I demonstrate this with two cases, using the approximate data from actual put trades that have occurred over the past two weeks.

When I began watching this activity, the price of Herbalife stock was at $48.00. The prices of the $47.50 and $45.00 puts were $5.00 and $2.00 respectively, so those are the numbers I use in this analysis.

Hypothetical trade #1 consists of buying 6,250 naked $47.50 HLF puts at a price of $5.00, for a cost of $3.1 million. This is compared with shorting an equivalent 625,000 shares of common stock at a price of $48.00, which is a $30 million trade.

The results are as follows:

Share price

% change

Short stock P&L

Long $47.50 put profit

Cost of $47.50 puts

Total put P&L

Put inferiority

$30.00

-37.5%

$11.3 m

$10.9 m

($3.1m)

$7.8 m

($3.4m)

$35.00

-27.1%

$8.1 m

$7.8 m

($3.1m)

$4.7 m

($3.4m)

$40.00

-16.7%

$5.0 m

$4.7 m

($3.1m)

$1.6 m

($3.4m)

$42.50

-11.5%

$3.4 m

$3.1 m

($3.1m)

-

($3.4m)

$45.00

-6.3%

$1.9 m

$1.6 m

($3.1m)

($1.6m)

($3.4m)

$48.00

0.0%

-

-

($3.1m)

($3.1m)

($3.1m)

$50.00

4.2%

($1.3m)

-

($3.1m)

($3.1m)

($1.9m)

$55.00

14.6%

($4.4m)

-

($3.1m)

($3.1m)

$1.3 m

$60.00

25.0%

($7.5m)

-

($3.1m)

($3.1m)

$4.4 m

As we can see, if a fund were to pay $5.00 for $47.50 puts, they would then be "net short" at a price of just $42.50, which is 11% below the entry share price of $48.00 for shorting common stock. So even if the share price declined by 11%, the fund would make precisely nothing on the put trade, vs. making 3.4 million on the short common trade. By getting short stock at $48.00, the fund would make 50 cents per share ($313,000) before the $47.50 puts even became in-the-money based on just a 50 cent decline in the stock.

If the share price were to decline by 37.5% to $30.00, a huge move, the put trade is still inferior because the fund would be short at a far lower price due to the option premium paid. The "inferiority" amounts to a consistent $3.4 million in lost profits for any meaningful downside move.

The only benefit to the put trade is that potential losses on the upside are limited $3.1 million (the price paid for the puts), whereas potential losses on a short common stock position are (in theory) unlimited. But in reality, the fund could easily start covering the short common stock position if the share price started rising more than expected, and thus losses would be cut early.

And in reality, for smaller (more expected) moves in the stock, the short common stock position is profitable, compared with the put trade, which will experience substantial losses for moves less than 10%. If the stock drops 10% (to $43.20) the fund would make $3 million by being short common stock vs. losing $437,500 if long the puts after paying $5.00 for them.

Going further out of the money, hypothetical trade #2 consists of Buying 6,250 naked $45.00 HLF puts at a price of $2.00, for a cost of $1.3 million. This is compared with shorting an equivalent 625,000 shares of common stock at a price of $48.00, which again is a $30 million trade.

Share price

% change

Short stock P&L

Long $45.00 put profit

Cost of $45.00 puts

Total put P&L

Put inferiority vs. short stock

$30.00

-37.5%

$11.3 m

$9.4 m

($1.3m)

$8.1 m

($3.1m)

$35.00

-27.1%

$8.1 m

$6.3 m

($1.3m)

$5.0 m

($3.1m)

$40.00

-16.7%

$5.0 m

$3.1 m

($1.3m)

$1.9 m

($3.1m)

$45.00

-6.3%

$1.9 m

-

($1.3m)

($1.3m)

($3.1m)

$48.00

0.0%

-

($1.3m)

($1.3m)

($1.3m)

$50.00

4.2%

($1.3m)

($1.3m)

($1.3m)

-

$55.00

14.6%

($4.4m)

($1.3m)

($1.3m)

$3.1 m

$60.00

25.0%

($7.5m)

($1.3m)

($1.3m)

$6.3 m

Once again, we can see that the only benefit to such a trade is in capping potential upside losses, which as we know are preventable anyway. Again, if the stock moves down less than expected, the put trade incurs substantial losses as opposed to decent gains on being short common stock.

So the conclusion here is obvious: no one with the money to afford such a trade would ever place such a trade simply due to the inferior economics and risk / reward proposition that it presents.

Part IV - So what is the whale really doing?

Now that we know what the whale is NOT buying puts, it is useful to evaluate how attractive the "covered put" trade is. This shows the superior economics of such a trade under nearly all circumstances.

Here I assume that the whale is short $30 million in HLF common stock, and that he has been selling the expensive puts to collect the high premiums that they offer as a result of the heavy bidding by uninformed speculators.

Once again, we assume that the whale got short at a price of $48.00, which is where the stock was when the options activity started picking up. The analysis below assumes the whale has been selling $47.50 puts and collecting $5.00 in premiums.

Share price

% change

Short stock P&L

Option premium collected

Loss on short puts

Total P&L

1-month return on $30m

$30.00

-37.5%

$11.3 m

$3.1 m

($10.9)

$3.4 m

11.5%

$35.00

-27.1%

$8.1 m

$3.1 m

($7.8)

$3.4 m

11.5%

$40.00

-16.7%

$5.0 m

$3.1 m

($4.7)

$3.4 m

11.5%

$42.50

-11.5%

$3.4 m

$3.1 m

($3.1)

$3.4 m

11.5%

$45.00

-6.3%

$1.9 m

$3.1 m

($1.6)

$3.4 m

11.5%

$48.00

0.0%

$0.0 m

$3.1 m

$0.3 m

$3.4 m

11.5%

$50.00

4.2%

($1.3)

$3.1 m

$1.9 m

6.3%

$55.00

14.6%

($4.4)

$3.1 m

($1.3)

-4.2%

$60.00

25.0%

($7.5)

$3.1 m

($4.4)

-14.6%

As we can see here, this is a very slightly bearish trade where whale wins nicely under most expected circumstances.

  • If the stock falls dramatically for any reason, the whale makes an 11.5% return on $30 million in one month.
  • If the stock falls just a little, or even stays flat, the whale also makes 11.5% on $30 million in one month.
  • Even if the stock rises back to $50.00 the whale still makes 6.3% on $30 million (in just one month) simply due to the high option premiums he collected from punting speculators who had hoped for an "event" vs. the relatively small losses incurred on the short stock position.
  • Only if the stock rises dramatically does the whale lose anything at all, and he always has the option to cover his short position early to prevent this.

For purposes of this analysis, I have assumed a trade size of $30 million because it matches up well with the trade sizes for individual strikes. But as we have seen from the massive options activity, the trade has likely been going on for several weeks and is likely to be in the size of $200 million or more. Given the demonstrated low risk profile of this trade, there is no reason why a large fund would not do this, and the capital requirements of a "covered put" trade are clearly offsetting, and therefore much smaller than a naked trade on either side, so it is not overly capital intensive.

The conclusion that we can reach from this is that there is likely a whale out there who just made more than 10% in a single month on at least $200 million, using a very low risk trade that takes advantage of smaller naked speculators on a controversial name. The controversy surrounding Herbalife is what allowed the put premiums to be bid up to such unreasonable levels, and that's what made this trade work.

The other conclusion we can reach is that (similar to QCOR) whoever engineered this relatively simple covered put trade will be having a very Merry Christmas.

Part V - What do we learn from this ?

Piling in to a crowded short trade often has a habit of ending up quite badly for those who choose to blindly speculate in such a way. And when the trade is wrongly perceived as a "sure thing" the results are typically even worse due to the tendency of investors to increase their size inappropriately.

A good example of this was the "sure thing" short trade, which many speculators piled into ahead of the much anticipated lock-up expiry for Facebook (NASDAQ:FB). With over 800 million shares becoming available for sale, and by insiders with a very low basis, it seemed like a precipitous drop in the stock was virtually guaranteed. In advance of the expiration, Facebook was trading below $20.00, but by yesterday (Thursday) the stock closed at $27.32, up more than 35%. Losing 35% in the course of just 2 weeks is unpleasant enough on its own, but the simple fact that because a decline in Facebook was perceived as "guaranteed," persuaded many investors (big and small) to get far too big into the trade, making the absolute dollar losses all the more substantial.

The short squeeze in Facebook was very notable for a company of its size, indicating that short bets against it were enormous. Once investors realize that Herbalife is not being bet against by the whale, the stock could also experience substantial short covering, driving the stock back up to $50.00 or above.

Chasing Research in Motion (RIMM) down to its inevitable "zero" has recently shown similar results for shorts focused on a "sure thing."

Shorts are not alone in their over-enthusiasm for the "guaranteed" trade. Long investors in Apple Computer (NASDAQ:AAPL) were steadily following a mantra of "Apple $1,000" despite the obvious valuation problems this would pose for such an enormous company (even despite its spectacular growth and large cash position), and the decline from over $700 per share has been unpleasant for many who jumped onto the bandwagon too late.

As it pertains to Herbalife, it should be realized that the simple motto of "buy low, sell high" applies to options just as much as it does to stock prices. When options are cheap, buying them can be a good idea, but only if one has some clear view on the timing of a share price move. However when options are overly expensive, and especially when an investor has no clear idea on the timing of any major move in the share price, then entering covered option trades can prove to be quite profitable and can be safely done in fairly large size. However it should always be kept in mind that keeping an effective hedge, as the whale did, is critical for preventing catastrophic losses when selling options.

For the time being it seems that the smartest move investors can make with Herbalife is to simply stop lining the pockets of the whale by no longer bidding up the price of the put options in the absence of a clear catalyst for a significant downward move in the stock.

As for me, I am short shares of Herbalife from a price of $46.96, but recently sold a number of puts to take in the large premium against this position.

The author can be reached at comments@pearsoninvestment.com

Source: The Surprising Truth Behind Herbalife Put Volume

Additional disclosure: The author spent 9 years structuring equity and equity linked derivative securities at a major Wall Street investment bank.