When going short goes badly wrong

News that the Federal Trade Commission is poking its nose into the company Herbalife probably had investor Bill Ackman jumping around on his desk, with his fists clenched and his eyes squeezed shut, going "Yesssssss!"

Ackman is a big-time investor who has made a billion-dollar bet (actually $1.2 billion) against Herbalife. He's like a gambler at a race track putting a huge chunk of money on a horse to not finish the race. Ackman's argument is that the horse (Herbalife) is such a busted up old nag that it will drop dead before it reaches the finish line. Herbalife, he says, is a pyramid scheme and a parasitic business model that simply can't sustain itself. The company, he argues, will eventually drop dead, and anyone who has invested in it will lose all their money.

Ackman's opponents say that he's more like a gambler who has made a huge bet, and is determined to make it pay by bad-mouthing the horse. Ackman, they say, has been publicly smearing the company for the last two years in order to drive the stock down.

Patrick Curtis, of WallSteet Oasis, puts it like this: "Ackman's money-making strategy is called short-selling.  He has effectively borrowed $1.2 billion worth of Herbalife shares and sold them. If the price of Herbalife shares fall, he can close the transaction by buying and returning the shares at a lower price and pocketing the difference.  For example, if the value of the Herbalife stock that Ackman sold dropped by $500 million (or about 40%), then he would be able to close out the position for $700 million and profit roughly $500 million (excluding fees and borrowing costs). "
 
Curtis says it's important to note that Ackman does not own the shares after the transaction is closed.  He never owned them and when he buys and returns, it's all done through an intermediary, such as a brokerage house or bank in one step.
 

Unfortunately, things haven't gone quite so smoothly. Instead of going down, the stock's price has risen. By more than 50 percent. Ackman is now, in trader parlance, "out of the money," which means if Ackman had to return the shares he owes today, he'd end up paying a lot more for them than he got when he sold them way back when.

And that's why the FTC decision is such a big deal for Ackman. He's hoping the regulators will drill into Herbalife and vindicate his claims that it is, in fact, a pyramid scheme. If that happens, investors will likely run for the hills, the stock will almost certainly crash, and Ackman will make out like a bandit. But if the FTC says Herbalife is fine, then Ackman could find himself very badly needing a drink.

Full disclosure: my Dad used to sell Herbalife products. He had a big sign on his car saying "Lose Weight Now - Ask Me How!" (It was super embarrassing.)

About the author

Paddy Hirsch is a Senior Editor at Marketplace and the creator and host of the Marketplace Whiteboard. Follow Paddy on Twitter @paddyhirsch and on facebook at www.facebook.com/paddyhirsch101
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