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Trades

Trade Opportunity in Kraft Heinz Fallout

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The past two years have been strange for nearly all companies. Stocks that were supposed to have a rough time of it – like Facebook, following the political pressure surrounding its “fake news” problem – have been able to power through to do quite well. It is up more than 50% since the start of 2017.

Others, that have proven even bad times can still provide reliable share price growth in the past have collapsed stupendously – like General Electric, losing more than two thirds of its value in that period.

But no company has surprised investors quite like Kraft Heinz Co. (KHC):

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The company had just completed its historic merger between Kraft Foods and H.J. Heinz in 2015 to become one of the world’s largest and most iconic food businesses.

The deal that brought these two giants together was especially remarkable because it was spearheaded by the likes of Warren Buffett, who now owns 27% of the company – a large stake even for him.

Many have long viewed both companies – and after the merger, the combined company – as a true “safe stock.” Meaning, no matter what the global economy would look like under a Trump Administration and post-Brexit Europe, companies like Kraft Heinz would be solid.

But as you can see above, it didn’t turn out that way for Buffett and company. The stock had never quite lived up to the over-the-top synergies the combination of businesses were supposed to see. So, even before a bombshell that came earlier this year, things weren’t going great to start with.

However, no discussion surrounding this company would be complete without a recap of the February event.

On February 21 of this year, KHC announced its fourth quarter 2018 results. They shocked everyone. The company not only badly missed analyst estimates. It became instantly clear that everyone would have to reevaluate the company.

The consumer staple was forced to write down $15.4 billion worth of its assets including its own Kraft brand. That would be monumental by itself. But it got worse for Kraft Heinz.

Management also announced it was under SEC investigation for problems in its procurement practices. Not only under investigation… but had been for months without telling anyone.

This was bad. In a single day, the company’s stock fell 27% losing more than $16 billion in market value. Clearly, this once “safe stock” was now toxic. Buffett’s own stake fell $4.3 billion in the panic. Since then, his Berkshire Hathaway had to write down $3 billion of its own in this disaster.

If only this story was over. While not nearly as major of news, it has had one final bit of ugliness since then. In March, the company received notice from Nasdaq, where its stock is listed, that it fell out of compliance by delaying its annual 10-K filing. As we write, more than a month and a half later with its 10-Q just about due, it still hasn’t filed one.

This is not pretty for anyone that’d bought Kraft Heinz for its apparent safety and dividend over the last few years. Oh, it’s cut that down too by more than one-third in this mess. But, sometimes, when all else looks dire, opportunities arise.

Supposedly, sometime over the next week, the company will announce its first quarter results to investors. Now, we aren’t going to speculate on what those will be – or even if it happens as expected. The important thing to note is that investors believe it should happen and wait eagerly to find out what the company will say.

Options investors have a tremendous advantage here. You see, most stock investors are forced to bet whether a company’s share price will go up or down. With so much uncertainty around Kraft, that’s a tough bet to make. Options investors can profit without needing to do that, however.

There’s a strategy we often use around here that lets traders invest in the expected increase in volatility – rather than direction that volatility ultimately takes the underlying share price.

Let’s take a look at this strategy now for use on this strange Kraft Heinz situation.

A Strategy For Short Term Volatility

A long straddle is a type of trade that involves buying both a call and a put option on a stock with the same strike price and expiration date.

The idea behind this strategy is to trade on the notion that its stock cannot sit still in the coming few weeks or months. It will have to move one direction or the other. But it doesn’t make a distinction – in terms of profit potential – between the two.

If shares plummet, the put pays out handsomely. If it does extremely well, the call will. The risk is known up front – the total entry cost to get into the trade. Yet, the maximum profit potential remains near limitless. The larger move, in either direction, the more profitable this kind of trade becomes.

You can see how that works here:

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Source: The Options Industry Council

For a company like Kraft, which has investors intensely interested, this is an ideal way to play whatever comes next.

Let’s look at a specific example to show you what we mean.

A Specific Trade on KHC’s Volatility

A trader looking to use a long straddle strategy on KHC’s upcoming news cycle, could buy a June 21 $32.50 call for $1.52 per share and a June 21 $32.50 put for $1.35 per share for an entry cost of $2.87 per share. Since each represent 100 shares of Kraft Heinz, that’s a total net debit of $287.

That’s the most the trader would have at risk for the whole seven-week duration of this trade. But the profit potential is much, much larger.

As noted, there’s really no limit to how much a trader could make on this. If KHC somehow comes out of this period reassuring its investors that it had sorted its plethora of problems, the call could end up being worth thousands. OR, just as likely, if the company slips up yet again, shares would collapse further, benefiting the put options on this trade.

To find out just what price shares of KHC need to hit for this trade to turn a profit, we need to look at this cost in relation to the strike price.

If shares fall, the put side of this trade would earning enough to cover the cost of it as they drop below $29.63. To find that, subtract the total cost from the strike ($32.50 – $2.87 = $29.63).

On the other hand, if shares rally, the call hits its profit threshold at $35.37 ($32.50 + $2.87 = $35.37).

In either case, that means shares of KHC would have to move by 8.8% by June 21. In most consumer staples, that might be a large amount of price action. But for a company that investors aren’t even sure will report to the SEC on time, that’s tiny.

So, instead of trying to guess what happens with Kraft, this strategy lets investors trade on the fact that something will. And investing in volatility seems about the only good way to play it.

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