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Icahn schools Ackman on options

Jon "DRJ" Najarian (ask-drj@optionmonster.com)

When I first learned of Bill Ackman's thesis and subsequent short position in Herbalife, I thought I smelled a rat. I say that not because I dislike the mega-successful hedge-fund manager, but because of how he chose to divulge his short position and how he took on his short exposure. I thought shorting a hard-to-borrow stock rather than buying puts was his first monumental mistake.

You will recall that Ackman announced this short in a special presentation at the Ira Sohn research conference. I thought it odd, even suspicious, that he announced this massive short position just two days before the December option expiration. It smacked of an attempt to panic investors to dump their long positions and create a feeding frenzy for the shorts.

Looking back, it worked--but only temporarily. Ackman cried fire in a crowded theater and panicked investors, who immediately hit the exits. HLF plummeted from $44 to $24.24 in just four sessions (Dec. 18-24, 2012), but here is where Ackman made his second big mistake: He didn't cover a single share.

That is a blatant violation of our Hog Principle ("pigs get fat, hogs get slaughtered"). Translated from Wall Street vernacular, this means that it pays to be greedy, but not too greedy, lest you can end up losing it all.

Now Carl Icahn didn't get to be a multibillionaire by being stupid. He saw an opportunity in HLF on the Ackman-induced selloff and decided to seize the opportunity. However, rather than just buying shares, Icahn got into some mid-term and long-dated calls and puts to express his bullish outlook .

Contacting an undisclosed investment bank, Icahn bought over-the-counter (:OTC) calls controlling 3.2 million shares of HLF and financed the purchase with the simultaneous sale of OTC puts that would obligate him to buy 3.2 million shares of HLF with a May 2013 expiry. He also purchased OTC calls controlling 8.3 million shares and financed same with the simultaneous sale of OTC put options that obligated him to buy 8.3 million shares of HLF with a January 2015 expiry.

As time has shown, Icahn not only feasted on Ackman and other shorts in HLF, but he showed them how to trade.

You see, when you are short a stock your gains are dollar for dollar. For example, if the stock you've shorted drops $5, you make $5. If it rises $3, you lose $3. It's a linear equation.

On the other hand, a put option can cost only you what you paid for it. The contract gains value when the stock drops and loses money when stock rises, but only to the extent of the premium you paid for the put.

So if Ackman had bought puts when he entered his short at $45, he could would have lost only what he paid for them. But instead he shorted shares, which means he could lose dollar for dollar up to $72, or wherever HLF goes.

I did a quick calculation on a two-year, at-the-money $45 strike put when HLF was trading $45 and came up with a valuation of $11. If Ackman had bought those puts instead of shorting shares, he would lose only $11 over the next two years. To show why this limited-risk strategy is so superior to shorting the stock, I outlined what happened to those puts in the next 11 months.

Based on that $72 price, I calculated that there are only 15 months left in that put's life, and my tradeMONSTER system determined that those $45 puts would be worth $3, or a loss of $8 per contract (from $11 purchase price). Had Ackman had these puts on the equivalent of 20 million shares (his declared position) he would have lost $8 x 20 million, or $160 million.

Contrast that to the $27 run from $45 to $72 for Herbalife, and you see that this strategy would have reduced the exposure of Ackman and his investors to less than 1/3 of the losses they have suffered. Those 20 million shares he was short cost him $27 x 20 million, or $540 million!

Yes, these are both huge losses, but players such as Ackman are trading huge positions. I suspect that if he had lost $160 million versus $540 million, he might be willing to double down at $72. But instead, he is now taking a page from Icahn's playbook by buying back 8 million shares and substituting those short shares for OTC put options.

Icahn may have picked Ackman's pocket, but at least he taught him a valuable lesson about the value of trading options.

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