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Editor's Note: Shah shared this true "billionaires' brawl" on Dec. 17th. Today, as promised, he'll show you how to make money from it. Take notes…
Sure, the Herbalife game that pitted Bill Ackman against David Einhorn, Dan Loeb, Carl Icahn, and the rest of the billionaire boys' club was a tad bit personal.
It was also professional, very professional.
All the billionaires playing the Herbalife game are professional money managers. They made their mega fortunes in the markets.
But you don't have to be a billionaire to make money in the game.
In fact, you can play the same game and profit nicely by understanding how to follow their lead.
After all, that's what they're doing.
So let's start with someone taking a position, like David Einhorn shorting Herbalife…
You Can Play His Game, Too
Einhorn originally shorted Herbalife based on research he bought from The Indago Group, a research boutique that bashed the company's business model and its elevated stock price. While we don't know exactly when Einhorn's Greenlight Capital Re (Nasdaq: GLRE) began shorting the stock, it was probably in March and April of 2012. The stock was hitting new highs in the $70 range, after rising from under $7 in 2009.
Einhorn knew that other hedge funds were getting Indago's research and getting pitched on shorting the stock. He didn't have to advertise shorting the stock – that was being done for him. All he had to do was initiate a short position, which he did.
By the way – if you're going to short a stock, one place to start is to try and knock it down from its highs. If you're wrong and the stock makes new highs, chances are you can get out at some higher price without too much pain. It's a game called picking tops and bottoms.
Einhorn wasn't ready for the world to know he was short. He liked that the price was high; it gave him an opportunity to short discreetly at elevated prices.
With the stock in the low mid-$70 range, on Herbalife's analyst call on May 1, 2012, Einhorn got his chance to "talk his book."
When a trader talks his book, he's telling you what he wants you to hear. If he's short he's going to say terrible things about the stock because he's short and wants you and anybody listening to hate the stock too, and, of course, sell it.
Einhorn now wanted others to know he disliked the stock. By questioning the CEO on the company's business model, essentially implying it was a house of cards, he let the listening world know that he was short.
Why else come on the call and challenge the CEO? That's talking up your book…big time.
Bill Ackman's people were also on the earnings call. They told their boss what had just happened and he immediately began heavily shorting the stock… big time. Herbalife dropped to the low mid-$40 range by the end of that trading day.
That's how it works. And here's how to make it work for you…
Rule No. 1: Find Someone to Follow
There's nothing wrong with following on any successful investor's or trader's coattails. Again, that's what these guys do. And they try and get others to follow their picks.
One of the ways to play along would be to catch news of the big stock drop and see why it fell like a stone. Or you might run "scans" that alert you to unusual upside or downside action in any stocks. That's always a good way to find moving candidates.
Even if you found Herbalife falling out of bed, chances are if you did a little homework you'd find that some hedge fund honcho was betting against the stock.
Now you've got someone to follow. And since you know Einhorn's a big player, you could feel comfortable playing along. But what if the stock already dropped and Einhorn had been "talking his book" on the earnings call to knock the stock down so he could take his profits? You don't know.
There's always risk.
So, the best plan is to watch the stock for a few days, and see if it goes down on little volume. But if it bounces a little after the big drop, again on little volume, see how high it might go and short some shares on the bounce. It's not prudent to put your whole trade on at once. If the stock goes a little higher you can add to your position.
Because you're following a professional, and don't want to get gamed yourself, make sure to have a reasonable stop-loss in mind to get out of the position if it's going against you and you're not willing to take on the increasing loss.
But, you're following a pro, and chances are, especially in the case of what was being said about Herbalife, putting on a short was likely to put you in like-minded company.
That's how you follow a billionaire.
In the meantime, you probably didn't know Bill Ackman and his Pershing Square Capital were shorting the stock too.
Then, since you should be following every bit of news and rumor about Herbalife (you can set up Google alerts to follow any news items that hit the Internet), you heard that another billionaire was shorting the stock and "talking up his book."
You probably wouldn't have been invited to the Ira Sohn Conference special meeting Ackman asked for so, he could really talk up his book. But, if you were following Herbalife you would have heard about it after the fact.
And it would have been music to your ears. You would have learned that Ackman the billionaire had accumulated a massive short position and was calling for the stock to collapse. Now, if you or I manipulated a bunch of folks into shorting a stock because we were short, it might be called manipulation, but when a billionaire money manager does it, it's called talking his book.
Once you've started following successful investors and traders, move on to the next lesson…
Rule No. 2: Don't Be Too Greedy
Why not? Because while you think they are greedy and want to make the most out of the trade themselves, you'd be wrong. They are greedy, but they want to make money, and "ringing the register" with a big fat gain is always good.
Ackman's talking his book at the special meeting he called for on Dec. 20, 2012, caused the stock to tank. And since Rule No. 2 is not to be too greedy, just greedy enough, a few days after the special meeting, as the stock was falling, would have been a great time to at least take off half of your position. If not, book your nice gain in only a few months and look for another billionaire trade to follow.
Too bad for Bill Ackman he wasn't following Rule No. 2, and – worse – forgot about Rule No. 3…
Rule No. 3: Know Where the Other Billionaires Stand
Rule No. 3 is this: A position, any position, is one thing to one person, something else to another. You better know how the other side thinks…especially if it's another billionaire.
It doesn't matter that people didn't like Bill Ackman and maybe wanted to screw him. What matters is the trade and who is doing what to your position?
On the other side of the Herbalife short, traders were figuring out that Ackman had a huge short in a thinly traded stock and if they bought enough stock they could squeeze share prices higher, betting against all the shorts.
And that's what happened. Dan Loeb and Carl Icahn came in and started buying the stock. Loeb said it would go back to the seventies. Icahn just said Ackman was a fool and there was nothing wrong with Herbalife.
At that point if you were greedily still short you should have run for cover. If you had already covered your short, guess what, now you had another billionaire, a much richer, much more successful professional trader and investor to follow. You should have followed Icahn and bought the stock.
David Einhorn? He covered his early short way back, he wasn't greedy, he rang the register early, probably too early, but he made a lot of money.
Dan Loeb? He bought Herbalife and didn't stay in for the ride back to $77, where the stock is now. He said it was worth $75, but he's not greedy. He probably sold his stock that he bought in the upper $20 range to Carl Icahn when Icahn began buying more stock when it hit the forties.
Loeb wasn't greedy. He got out too soon, but so what? He made a lot of money; he rang the register.
Now Carl Ichan and a lot of his followers, a lot of other billionaires, like Herbalife. Especially because Carl wants to maybe take it private… again.
This Is How I'd Play It Now
I'm not greedy. If I owned it up here I'd put a stop order down to sell if the stock goes below $70. So what if you get stopped out at $70 with a profit and the stock goes a lot higher? You still rang the register.
If you want to play the billionaires' game, play it the way the smart and not-too-greedy players play the game. Follow leaders, listen to who's talking their book, go along for the ride, and ring the register.
These billionaire traders aren't billionaires because they are never wrong. They're billionaires because they constantly ring the cash register. You should, too.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.