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The allegations of fraud against the Chinese industrial Harbin Electric, Inc. (NASDAQ:HRBN) by Citron Research has generated a lot of interest among speculators to take short positions in the stock. For those like myself that have gone through enough material to believe Citron's report, this article explains why the most interesting short position to enter (at the time the article was written) is with $16 and $23 December put options.

The rationale goes as follows:

Timing
Harbin Electric CEO Tianfy Yang claims that he will take HRBN private at $24/share by the end of the year through Tech Full Electric Company Limited (a limited liability firm that he set up in the Cayman Islands). This gives the CEO a 6 months life line to either execute the buyout, admit he is a fraud, or come up with some other shenanigans to delay that "deal". So we will be looking at the December 2011 options.

Buying Puts vs Shorting Calls or Shorting the Stock
Shorting stocks and options exposes one to unlimited loss potential (in theory). In practice, the stocks are extremely expensive to short (when possible), and over a 6 months timeline may cost more than the total value of the stock.

Shorting the call options is not interesting because HRBN call options' extrinsic value (time value) is considerably lower than its put options. And given the tendency of the CEO to create news to manipulate the price of the stock, I would avoid the unnecessary risk of being short a call. This guy could say he has an offer at $80/share and the stock will move up to $40 (notice how the stock hovers at around a 50% level between what the "buyout" price is and $1-$2).

Picking the Strike Prices
Based on intraday trading levels, I froze the option table when the stock was trading at $15 for the analysis. Using greeks would help if you're trading the option short term, but here the play is really to hold and see the stock tank to the $0.01 range, so we'll have no use of the delta, thetas, gammas, etc...

Using the ask prices of these options on that intraday option table, I built the following table.

Net Profit & Loss Per Strike Price
The following tables exclude commission & trading fees.

click to enlarge
HRBN December Put Options: Net Gain & Loss at Maturity

A quick look reveals how the Strike 30 and 25 are clearly overpriced. The December put option with the highest net potential is the $23.

However, converting this table into percentages reveals another candidate: the $16 strike price.

% Returns

The best %-performers by price at expiration are highlighted in green. The first break even zone begins at the $11 range for the strikes above $20.

The best risk-adjusted trades are currently (remember, this is based off current options prices and may change after the publication of this article) the $23, $16, $8 and $3 strike prices, with the $23 strike being the "safest" short, while the $3 strike is the riskiest while carrying the highest potential reward if the stock trades at $1.00 by expiration.

Given the already risky nature of options and the volatility of the stock and its CEO, the safer road to short HRBN is therefore with the $23 and $16 strike prices. Additionally, the satisfaction of carrying intrinsic value at entry will psychologically help you hold it longer than the far out of the money strikes.

Risk of Holding during a Trading Halt
There is a risk to be aware of when holding put options on a stock that is halted. Recently, many investors were burnt with these shady China stocks when their put options expired during a trading halt. The reason being that an option on a halted stock will exercise based on the latest trading price, even if the stock opens 99% lower on the following day. I recommend reading Barron's here regarding the real risk short sellers faced during a halt.

Disclosure: I am short HRBN.