Hedge funds have been lining up on both sides of the fence regarding nutritional supplement multi-level marketing company Herbalife Ltd. (NYSE: HLF). The stock made a 52-week high of $73 last spring before shares took a huge hit following accusations from hedge fund investor William Ackman that the company was nothing more than a pyramid scheme.
The seven-month trading range between $56 and $42 a share projected a downside target of $28 ($14 height of the pattern subtracted from the breakdown level of $42). A volatility spike occurred when the downside channel support at $42 was broken in December, and as often happens at price extremes, the selling pressured the stock to $24 before a rebound.
Recent action has seen the price rally back above breakdown point at $42, which acts as the pivot point, to about $44. As the battle between short sellers and value buyers continues, traders can use a different approach to profit from Herbalife.
Because of the high volatility (another word for opportunity), the options on the stock offer many strategies with mathematical advantages over a straight purchase of the shares. In particular, selling put options could allow us to collect income while we wait to get into the stock at an even bigger discount.
While the typical investor might use a limit order to buy a stock or exchange-traded fund (ETF) at a designated price or lower, the options trader can do one better by selling a cash-secured put.
This strategy has the same mathematical risk profile as a covered call. With put selling, there is an obligation to buy the stock at the strike price if it is assigned, allowing you to get into the stock at a discount. In fact, the true entry cost basis is even lower with the subtraction of the premium you earned from selling the puts.
And if the stock is not below the strike price at expiration, then the premium received is all profit. In other words, you're getting paid not to own the stock.
There are two rules traders must follow to be successful at selling put options.
Rule One: Only sell puts on stocks you want to own.
The intention of this strategy is to be assigned the stock as a long-term investment (each option contract represents 100 shares). So make sure you have the funds in your account to buy the stock at the options strike price if a sell-off continues. Paying in full ensures that no additional money is needed to hold the stock for potentially many months or even years until a price recovery.
Rule Two: Sell either of the front two option expiration months to take advantage of time decay.
Collect premium every month on put sales until you are assigned shares at a cost-reduced basis. Every month you keep the premium is money subtracted from your entry price.
Action to Take --> Sell to open HLF Feb 30 Puts at $1 or better.
This cash-secured put sale would assign long shares at $29 ($30 strike minus $1 premium), which is about 34% lower than Herbalife's current price, and would cost you $2,900 per option sold. Remember: Only sell this put if you want to own Herbalife shares at a discount to the current price. If you are assigned the shares, a March covered call can be sold against the stock to lower your cost basis even further.
And if the stock does not fall below the strike price before expiration, then you keep the premium you collected, essentially getting paid not to buy the stock.
This article originally appeared on ProfitableTrading.com:
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