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This Problem Plagued Company Might Be Ready to Deliver Big Gains

This Problem Plagued Company Might Be Ready to Deliver Big Gains

Some companies can face problems that take years to resolve. As the New York Times reported,

Herbalife (NYSE: HLF), a nutritional supplement company that was once the focus of attacks by a well-known hedge fund manager, reached a settlement on Friday with securities regulators over allegations it misled investors about its business practices in China.

The company agreed to pay $20 million to the Securities and Exchange Commission to settle claims that it misled investors for six years and told them that its business practices in China were different from its operations in other countries.

The settlement comes a little more than a year after the hedge fund manager, William A. Ackman, raised the white flag and ended a prominent bet that shares of Herbalife would collapse because he believed it was running an unsustainable pyramid scheme.

Mr. Ackman, who runs Pershing Square Capital Management, had bet as much as $1 billion on the collapse. He began his crusade in 2012 with a three-hour presentation that he called “Who Wants to Be a Millionaire?” To support his campaign, he produced a number of critical reports about the company.

One of Mr. Ackman’s critiques focused on Herbalife’s activities in China. A 2014 presentation said that “Herbalife violates China’s directing-selling and pyramid-sales laws.”

The settlement with the S.E.C., in which Herbalife neither admitted nor denied the allegations, is not the first time the company has been penalized by a regulator over its business practices.

In 2016, a $200 million settlement with the Federal Trade Commission required Herbalife to hire an outside monitor and make substantial changes to its business practices. But the commission let the company continue to operate, allowing it to avoid the regulatory death knell that Mr. Ackman had been banking on.

A spokesman for Mr. Ackman declined to comment. A spokesman for Herbalife did not respond to a request for comment.

“Herbalife deprived investors of valuable information necessary to evaluate risk and make informed investment decisions,” Marc Berger, the director of the S.E.C.’s New York regional office, said in a statement.

This could mark an important bottom for HLF.

HLF daily chart

The stock is at important long term support.

HLF weekly chart

A Trade for Short Term Bulls

As with the ownership of any stock, buying HLF could require a significant amount of capital and exposes the investor to standard risks of owning a stock.

To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.

Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.

To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.

This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

bull call spread

Source: The Options Industry Council

Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.

A Specific Trade for HLF

Every day, we scan the markets looking for trades with low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

For HLF, the November 15 options allow a trader to gain exposure to the stock.

A November 15 $37.50 call option can be bought for about $1.25 and the November 15 $40 call could be sold for about $0.82. This trade would cost $0.43 to open, or $43 since each contract covers 100 shares of stock.

The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.

In this trade, the maximum loss would be equal to the amount spent to open the trade, or $43.

The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

For this trade in HLF the maximum gain is $2.07 ($40- $37.50= $2.50; $2.50 – $0.43 = $2.07). This represents $207 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $43 to open this trade.

That is a potential gain of about 381% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.