ONE-TWENTY TWO - A collection of personal articles on financial markets including analysis you can use


Jan
15

Herbalife: Anatomy of A Short Squeeze

written by Dr. Duru
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In “A Trading Plan For Herbalife: A Pullback Likely Before A New Trading Range“, I used options trading and presumed resistance at the 50-day moving average (DMA) to estimate that this week would finally mark a pullback in Herbalife (HLF) shares. Instead, HLF punched right through 50DMA resistance on Monday (Jan 14) and in just two days has tacked on another 15%.


Herbalife continues to surge right past Ackman's attack line

Herbalife continues to surge right past Ackman's attack line


Source: FreeStockCharts.com

After I tweeted today about Karen Finerman of CNBC’s Fast Money explaining how a short squeeze could unfold in HLF, tweeter @brett34 tweeted me back:

“@DrDuru aren’t you the one that said this was going down a week and agreed with Ackman?”

This message surprised me because I have called Ackman brilliant for his original smashing of HLF stock, but I am far from agreeing with him. Moreover, I am long HLF stock. However, I appreciate feedback and take to heart that something in my writing may have suggested that HLF going down was a guarantee. As a writer, sometimes what seems clear in one’s head, does not come out clearly in writing. In the last piece, I gave an important disclaimer about trying to read the tea leaves in options trading:

“With options apparently biased bullishly – interpretations are fraught with the hazards of figuring out who is buying and selling between traders and market makers – I suspect that it will be much easier to detect a sudden interest in bearish bets than bullish bets.”

This came toward the end of my piece, so it was easy to miss. Here is what I was saying in different words – overall, the options trading tells me that no one is buying the idea that HLF is going to zero and certainly not anytime soon as Ackman expects. Whenever the market starts to believe that again, it should show up relatively well in the options trading. In the meantime, it seems traders are betting HLF will continue to go higher. However, the challenge in interpreting options trading is always the lack of visibility into who sits on what side of the trades. If market makers are buying options, then demand is to sell them and traders are bearish on those options. Vice versa if market makers are selling options.

For the current week, I made the following assessment and trading call:

“A new trading range is likely for another substantial period until a definitive event occurs involving the FTC and/or the SEC. In the meantime, I fully expect rumors, leaks, and emphatic interviews to drive the stock sharply toward the boundaries of the trading range. Until HLF marches through the thickets of a resolution, I will be biased toward shorting puts in the wake of forced selling. The first opportunity might come as early as this week.”

I was NOT suggesting shorting HLF or making a bearish bet. Instead, I was bracing myself for a pullback this week into which I hoped to refresh a short position on put options (NOT shares). It seems that pullback is not coming and based on the small pop in after-hours after Finerman’s comments on CNBC’s Fast Money. Here is what she said (copied straight from CNBC’s transcript starting around the 6:00 mark in the video):

“…the one thing i’m wondering, the phenomena we were talking about on the call today, when you lend your securities out or borrow them, forget actually which side, i’m wondering if somebody like a dan loeb takes his shares out of a margin account and puts them into cash unt, that takes them out of eligibility to be shorted. right. if he’s not the only one doing that, i wonder if that has the ability to create a short squeeze. and if we look, you know, today, we try to borrow shares, there was no boar record available.” (me: the last part was really “no borrow available”)



Finerman laid out a scenario under which Ackman could be forced to cover. Ackman’s position is so large that, if enough big fish like Loeb or Chapman and others collude to take their shares out of margin and into cash, short shares may be forced to cover. At a minimum, it could severely restrict the ability of NEW shorts to come in and add pressure to the stock. Robert Chapman laid out the anatomy of a forced short squeeze when he wrote in late December about going after Ackman’s short position although he did reference the mechanism of moving shares from margin to cash. (I posted my commentary in “Herbalife Gains A Big Friend In Robert Chapman As Bullish Momentum Rises“). Here is specifically what Chapman described as the anatomy of a forced short squeeze (see “Herbalife: Why I Made It a 35% Position after the Bill Ackman Bear Raid“):

Click image for a larger view…


Excerpt from Robert Chapman letter to shareholders, December 29, 2012

Excerpt from Robert Chapman letter to shareholders, December 29, 2012


So, the next question is how much of this attack did Ackman foresee or prepare for? HLF already had a large buyback program authorized. Perhaps he thought he could drive HLF to zero before the company could buy stock. That seems like a stretch. Is Ackman willing to take a $1B, $2B, even $3B hit so that he can stubbornly wait out the counter-attack? We cannot know ahead of time, but it sure seems like any individual investor thinking about shorting HLF here is playing with treacherous fires. On the flip side, we should all recognize that the hedgies going after Ackman are not fundamentally interested in HLF; they are interested in taking Ackman’s money THROUGH HLF. Once they have closed out their positions and taken profits off the backs of short-sellers, HLF will once again be vulnerable to fresh attacks from whoever managed to survive the beatings.

Be careful out there!

Full disclosure: long HLF

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