I typically do not have trades on that are net short options so the subject does not come up often but there are certainly lessons to be learned. I am talking about everyone’s favorite stock (apparently) to trade, Herbalife (HLF).
Bill Ackman had said late last week that he was going to present a webinar that would definitively prove his case that HLF was indeed a pyramid scheme and would effectively go to zero at some point in time in the future. The market believed him and the stock plummeted from the $64.75 area upon his announcement to about $54 on July 18 when he was talking on CNBC.
After he was done IV spiked about 25% and one could say it was a short term opportunity to short implied volatility and wait for things to settle in. For example, the July 27 expiration, 60/67 strangle could be sold at $3.50. Well, HLF was hardly done. The stock continued down and actually put in an overnight low at $50.50!
If I had sold the strangle, I could perhaps (and very dangerously) say: “Well, it looks like Ackman finally has made his case, this HLF is going to zero. I can just buy back my short puts because the 60 calls are toast!” The puts could have been bought back for about $3.90 towards the close. So, you would lock in a loss of $0.40 but that isn’t too bad for being dead wrong.
Wait! We are not done. I know someone could say that the 60 calls were toast but don’t tell the market that. As soon as Ackman began his webinar the stock traded straight up. By the end of the day, the stock was trading $66.50! Now, not only have you locked in your loser on the put side for a $0.40 loss, you are now looking at having to buy back your calls at $7.95! Sell something at $3.50, buy it back at $8.35.
Lessons Learned
That is called getting whipsawed and is a worst-case scenario for the short gamma trader. Without the proper and disciplined risk management, you are potentially setting yourself up for some major drawdowns. I like to say: “Selling option premium works very well…..until it doesn’t!”
