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So it turns out that Bill Ackman, with his hedge fund Pershing Square Capital Management, is the "big whale" behind the massive short position built against Herbalife (NYSE:HLF). Ackman indicated that he has shorted more than 20M shares with over $1B at risk. As of November 30th, 20.7M shares were sold short against HLF.

Assuming Ackman is not the entire position (supposedly legendary short sellers Jim Chanos and David Einhorn have also lined up against HLF), he was very busy adding to his portfolio in the weeks leading up to his damaging presentation on December 20th. The chart below shows two distinct waves of accumulated shorts: May 15th to May 30th where shares short almost doubled, and October 31st to November 30th where shares short increased by about a third.

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Shares short against Herbalife have soared over the past year

Source: short interest

In stark contrast to the growing short position, 21% of HLF's float, HLF's stock stood firm, even increasing for a while, during both ramps in short interest. Throw in $3.1M of insider purchases in November by Herbalife COO Richard Goudis, and I figured HLF was good for a small buy. I now recognize this as a tactical error given the main rumor had yet to get resolved: a surge in put buying aimed at profiting from some big event before the December 21st expiration. I should have been more patient and waited out the news cycle. With the endgame now known on HLF, I am taking in a lesson on interpreting dramatic options (and short) action with the proper context and a healthy dose of respect.

Throughout November, traders ramped up purchases of December puts. The targeting is quite clear given the periodic and limited surges in open interest in select strikes. The following charts from demonstrate how this worked. In almost each strike, the open interest had reached its peak well before the end of November.

Interestingly, the price of these puts barely budged throughout November while the stock dropped from $51.35 to $45.64 (a loss of 11%). The November $42.50 put even declined in price. Put buyers had to be confident in the coming December catalyst. I placed a thin, red vertical line to show where open interest either reached its maximum level or the vast majority of its maximum level.

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Traders target December puts in Herbalife


The focus on put buying is also clear from the increase in the open interest put/call ratio from about 1.1 at the end of October to 2.7 by the end of November. This ratio last hit such levels about a year ago during a brief spike. A similarly brief spike occurred in mid-May of 2011. The open interest put/call ratio was as low as 0.40 in March of this year.

The fascinating part about this trade is that it turned into one of the easiest jackpots traders can ever find (I was not smart enough to join the stampede). With puts amassed at the border of expiration, Ackman delivered an early Christmas on December 19th by announcing his plans to reveal his short thesis the next day. Traders next rushed for December puts at the lower strikes: $41.50, $35, $32.50, and $30. Across the board, the profits by Friday's close on these puts grew tremendously. Traders even reached for jackpots at the $27.50 and $25 strikes but ended up with little or nothing.

During November, December puts were not the only ones seeing action. Traders also loaded up puts with January expiration. The lower strikes of $40, $37.50, $35, and $32.50 became particularly popular at the end of November. Presumably, as the month wore on with little to no appreciation in the December puts despite the drop in the stock, traders moved to January puts to hedge the timing of the "big event." The charts below are also from with a focus on strikes with open interest of at least 1000 contracts. They represent 96% of all the January open interest.

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Open interest soars for January puts on Herbalife


Notice once again that the lowest strikes surged in volume once Ackman's show got on a roll.

Curiously, the open interest for February expiration across all strikes is only 1.4. A swell of open interest at the February $50 call is responsible for this big difference in the put/call ratio from the two earlier months. Based on the presentation above, you have likely guessed when the swell occurred: at the beginning of November.

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The February $50 call was very popular at the beginning of November


With HLF trading just above $50 at the beginning of November, the premium on the February $50 call was a high $7 or so. The value in those calls are now obliterated. HLF's stock had essentially gone nowhere for six months by that point, so it is hard to imagine why traders would have bought those calls. With hindsight and seeing the entire context, I am instead guessing that these calls were sold by some of the same traders loading up on puts in November, using the premium from the calls to offset some to all of the costs of puts. It is a high octane bet that can be done by those extremely confident in an imminent catalyst.

The volume of trading on Friday, December 21st suggests that traders remain as bearish as ever for January but after that there could be a lot more ambivalence. On volume, the put/call ratio for January was 2.3 across all strikes. For February, this ratio was only 1.2. May demonstrated similar ambivalence with a put/call ratio on volume of 1.2 versus an open interest put/call ratio of 1.5 (again, across all strikes). Most interesting for May was the appearance of a swell of put and call volume at just two strikes: 16,058 calls at the May $35 strike and 16,496 calls at the May $22.5 strike. I am assuming most of that will translate into a swell of open interest at those strikes. This ambivalence should lead to more volatility in the stock and less one-sided trading straight down…at least over the next several months.

With Herbalife set to conduct an analyst day conference on January 7, 2013 to answer the charges against the company, I am willing to hear them out and get their side of this story. If the COO's massive purchase of stock means anything, I have to assume he will be working hard to support the success of that presentation. The market's response going into and out from that meeting should be quite telling. For now, I am holding onto my small amount of shares, and I even sold a February put into Friday's plunge with the assumption that at some point HLF will experience a relatively large relief rally. Friday delivered a third straight day of high-volume selling with the stock reaching extremely oversold conditions; frequently such selling is followed by a sharp bounce. However, I have no appetite to hang around in HLF if the company's defense falls flat.

At this point, the immediate catalyst for HLF has ended even as the endgame awaits at some point in the distant future. Ackman seems to have loaded up his position and will sit back and wait for the stock to drop to zero. For that to happen, he now relies on HLF's business to implode. He can also get assistance from investors whose selling continues to overwhelm demand for their shares and from other institutional shorts jumping into the fray. Regardless, it should get harder to move the needle on the overall short position, but if/when it does, I will assume that danger levels are once again increasing. The same assumption will apply to dramatic changes in the options trading.

Be careful out there!

Source: With The Endgame Known, Options Trading In Herbalife Provides Even More Insight