On Dec. 19, 2012, activist investor Bill Ackman (Trades, Portfolio) of Pershing Square Capital let it be known he was shorting Herbalife Ltd. (HLF, Financial) by a massive $1 billion. A day later he shared his reasoning at an investment conference. The fallout came quickly and hammered Herbalife shareholders, as this chart shows:
I might well have been among the thousands of retail shareholders who took a financial beating in the next few days. Fortunately, though, I had purchased protective put options when I bought the stock, and watched the value of my puts skyrocket as the price of the stock plunged (if only I had bought puts with some of the other disasters in my trading days!).
A protective put option is, in essence, much like the insurance policies you buy for your house and your automobiles. If the price of the underlying stock goes down, then your put will increase in value, offsetting the loss on the stock.
How much you offset depends on how much you are willing to pay for the puts, since they come in a wide range of values. While we don’t have space here to get into much detail about stock options, there’s a plethora of information online; as a starting point you might dip into the generally objective information available at the Chicago Board Options Exchange (CBOE), which handles most of the option trades in North America.
Here are two lesser-known strategies for buying put options when going long on a volatile value stock, Herbalife (again).
Herbalife as a Value Stock
The corporation currently has a place on the Undervalued Predictable list at GuruFocus, by virtue of its depressed valuation and its earnings consistency.
HLF earns 5 out of 5 Stars for predictability; only 59 of the thousands of U.S. stocks covered by GuruFocus have a record that good at the moment. And predictability matters: backtesting found that stocks with a 5-Star rating handily outperformed the benchmarks, and earned an average of 12.1% a year. Only 3% of 5-Star stocks held for 10 years were still in a loss position if held that long.
For valuation, we look to the Median P/S (Price to Sales ratio); on June 9, 2016 that value came in at $70.31, which is $7.87 or 12.6% above the closing price of $62.44.
In addition, as the following chart shows, the current price and median P/S are well below previous highs:
As to its overall financial strength, Herbalife Ltd. gets a Piotroski F-Score of 7, which is considered very healthy.
So, we have evidence that Herbalife is a value stock with some good upside potential. As we can see though, it's also prone to breathtaking drops.
Traditional Put Protection Strategies
Among retail investors, a protective put strategy usually means buying At-the-Money puts (quite close to the current price) and holding them through until expiry. Or, to keep the cost of protection down, they buy an Out-of-the-Money (strike price higher than the current price), put which provides less protection but also costs less, something like a high deductible on your auto insurance.
Relatively few investors use either strategy because the cost. For example, on June 9 Herbalife traded at $62.44 and a $62.50 (At-the-Money) puts expiring in January 2018 cost $1,500 (plus transaction costs, which are not included). Note that options contracts always come in units of 100, so this contract would be 100 puts at $15.00 each.
That’s the equivalent of adding an extra $15 per share to the price of the stock, to protect it for 19 and a half months. To break even, the stock would need to gain an average of almost 1% a month. That, as I say, is the traditional strategy, and not often used.
Alternatives to the Traditional Strategies
Strategy 1: The Higher-Strike, Early-Exit Put
Let’s begin by looking at prices for three different strikes on June 9:
Here’s a quick review of the terminology in each of the columns:
- OTM: Out-Of-The-Money put, which means its value is below the price of the stock.
- ATM: At-The-Money put, which means the value is close to the stock price.
- ITM: In-The-Money put, which means its value is greater than the price of the stock.
- Column A: the stock price at the time the options were priced.
- Column B: the strike price of the option, the face price at which owners will exercise their right to buy or sell.
- Column C: expiry date of the option, like the expiry date of your auto insurance.
- Column D: the cost of 100 puts (the standard size of an option contract), using the mid-point between bid and ask.
- Column E: the amount you would receive if you sold the options roughly two months before their expiry (more on this later).
- Column F: net cost for 17.5 months of put protection (selling two months before January expiry).
- Column G: number of months in the contract.
- Column H: cost per month of protection – matrix needs $ signs.
- Column I: the cost for one year of protection, based on the rates shown here.
- Column J: the cost of put protection expressed as a percentage.
- Column K: what you would receive if the stock price fell to $50 during the term of the contract.
As Column F in the matrix shows, there’s little difference in net cost between buying a $57.50 OTM put and a $67.50 ITM put — if you plan to sell them about two months before expiry. Here's that matrix again, with columns F and K highlighted:
While there may be little difference in the purchase prices, what a difference if the share price falls to $50 at any time before Nov. 21, 2017 (Column K). The $57.50 put sells for $844, and you have a net loss of $3.60 per share ($62.04-($62.04-$12.04+$8.44)). On the other hand, if you had bought the $67.50 ITM puts, you would have a gain of $5.69 ($62.04-(62.04-$12.04+$17.73). That’s a difference of $929, based on a $42 purchasing difference.
I learned the Higher-Strike, Early-Exit strategy mainly from RadioActive Trading, an online service focused mainly on option collars (a stock plus both put options and call options), for both long-term investing and swing trading (it offers a free booklet and webinars, and sells a course on collar strategies).
The early-exit prices come from OptionsProfitCalculator.com, which allows you to estimate the value of an option across a wide range of prices and expiry dates. Prices presumably are based on the Black-Scholesmodel; the website does not provide details. The following screenshot was taken after the close on June 10, when the stock price was $61.89.
The matrix shows the expected net gain or loss for specific prices (between $49 and $70) and expiry dates through Jan. 20, 2018, for $67.50 puts expiring on that date. Clicking on individual cells of a live matrix shows price you might expect to receive if you sell on specific dates and at specific prices.
You’ll note I used the words estimate and expected in the paragraphs above. Option prices depend not only on the price of the underlying stock, but also on the time until expiry and the volatility of stock. Volatility has foiled the plans of many a trader, including me! Ideally, you want to buy when volatility is low and sell when it is high, but of course the market doesn’t always give you what you want.
However, you can review the volatility history of a stock, so you know at least from where you’re starting. Go to iVolatility.com (you may have to register for a free membership), enter the symbol of the stock you want to check, and look for the IV Index put line. It will show you the current volatility, as well as the 52-week high and low (this is for volatility, not the share price).
I also like to look at the 1-year volatility chart, which you can find further down the page. It puts the volatility issue into perspective for me:
In this case, we see Herbalife's current volatility is reasonably low.
Volatility can be a good friend or a serious enemy for option buyers and sellers. Higher volatility increases prices and lower volatility makes them less expensive and valuable.
Strategy 2: Your Temporary Backstop
By now you may have asked, “What about stops?” Good question, since stop-loss orders (also known as just plain stops) provide many of the same protections as protective puts, at no cost. In making this comparison, we might say you get what you pay for; stops cost nothing — except for potential losses when one is triggered.
You place a stop-loss order at say $10.00, but the price drop has momentum and no buyers jump in until the shares get down to $8.00. You end up with a 20% loss because the price moved so quickly. To some extent, you can compensate by putting a limit on your stop-loss, so the shares quit looking for a new home when they reach a certain price, but there’s still some exposure to loss.
In addition, you might be whipsawed by a stop-loss; a temporary correction takes the price down far enough to trigger your stop, and then pops right back up again. To avoid this, you set your stop fairly loosely, but in doing so you increase your exposure.
A short-term protective put, combined with a stop, may help when dealing with a volatile stock. It might cost you, but by using the Higher-Strike, Early-Exit strategy you may find protection at a reasonable price. The OptionsProfitCalculator will provide an estimate what it might cost to buy and then sell well before the expiry date.
When selling the puts, we add our stop-loss and wait to see what the future brings. If the price of the stock goes up, we’re fine and don’t need to take any more action. Of course, we might ratchet up the stop-loss, or switch to a trailing stop.
If the price of the stock falls below our purchase price, where we set our stop-loss, then the stop will be triggered and our stock sold. As long as the stock hasn’t gapped down or fallen precipitously, our loss should be reasonably small.
Conclusion
Although stock options have a reputation for being risky, leveraged derivatives, they were originally designed to manage and reduce risk. We still can use them that way, to reduce our exposure to foreseeable (such as earnings reports) and non-foreseeable dangers.
With car insurance, most of us drive better vehicles than we would otherwise. With home owners’ insurance, most of us live in more pleasant places than we would otherwise. The same reasoning holds for protective puts: They allow us to take risks that we otherwise could not tolerate.
This is not to suggest we take on extra risk, but rather to emphasize we can manage it. While protective puts will not fit in many or most value investing scenarios, they are available. If I owned Herbalife today, I would likely spring for the $50-some dollars a month cost to sleep well. That protection becomes more affordable if we creatively manage stock options, using techniques like the Higher Strike, Early Exit.
And, having a bargain-priced, volatile stock with a solid floor provides a platform for other opportunities, including stock option collars. That’s a subject I’ll take up in a future article.
I do not own shares of Herbalife, nor do I expect to buy any in the foreseeable future.
