Herbalife Ltd. (NYSE:HLF) options trading idea via SFG Derivative Strategy analyst Christopher Jacobson.

SFG highlights an out-of-the-money call spread that we saw trade in Herbalife Ltd. (NYSE:HLF) yesterday and attempt to illustrate why it might not be as directional as it could appear on the surface.

Herbalife

Herbalife stock trades

While they typically have the least stock impact, it is often the furthest out-of-the-money option trades that garner the greatest attention due to the extreme moves that they may (or may not) imply. Yesterday, for example, we saw some interest generated by the purchase of 1,000 January 2014 95/105 call spreads in Herbalife Ltd. (NYSE:HLF). With the lower strike in this spread trading nearly 50% above the current stock price and given the volatility seen in the shares in recent weeks, we fully understand why investors would be interested in a trade such as this one. However, we believe it is important to focus on the implied risk/reward, and in turn the implied probabilities, when putting a trade like this into context.

See: Herbalife Ltd. (HLF) Shares Up, Cramer Calls Short Squeeze

In the case of yesterday’s trade, the spread was purchased for around $0.65 (the majority of the 95s trades around $1.74 vs. $1.10 in the 100 strike). The maximum value of this spread at expiration is $10 (simply the difference between the two strikes), which would be achieved at or above $105 at expiration. So, through this spread, the investor is essentially risking $0.65 to ?win? $9.35 ($10 less the premium paid), resulting in a 14.4:1 payout ratio. Intuitively, it makes sense that if the investor is getting nearly 15 to 1 odds on their spread, the likelihood of this event occurring must be fairly low.

See: Herbalife Share Borrowing Spiked In Recent Weeks

Assumptions on Herbalife stocks

Let us make a simplifying assumption and consider only two outcomes: 1) the stock stays below the lower strike ($95) through expiration and the spread goes out worthless; and 2) the stock goes through the higher strike ($105) by expiration and the spread goes out worth $10. Under this scenario, a fair price of $0.65 in the spread would imply a ~6.5% probability ($0.65 divided by the $10 spread) of the latter outcome. Put differently, 6.5% of the time we expect the spread to be worth $10, 93.5% of the time we expect the spread to be worthless, resulting in a fair price of $0.65. So, the buyer of this spread may not believe that a move to the ~$105 level is a favorite, or even likely at all, just that it is greater than the ~6.5% probability implied by the market. Viewed in this context, the trade may not appear as significant as it would on the surface.

(For the sake of simplicity we have ignored the outcomes between $95 to $105 in which the spread still has some value between $0 and $10. To account for these outcomes, we would typically say that this spread implies more like a ~6.5% probability of the stock finishing above $100, the mid-point between the strikes).