Traders Could Make 100% Betting Against This Potential Twinkie Savior

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Takeovers and takeover rumors can fuel large stock moves, often with the company being acquired going up and the company completing theacquisition falling.

These price moves are logical. Takeover targets tend to be undervalued and thebuyout is usually done at a price above themarket price . After the deal, it takes time to integrate the two companies and the acquirer could see short-term costs as they build a stronger business. While the stock price of the acquirer might move higher over years, in the short term, it often falls.

However, takeoverspeculation surrounding Hostess Brands has actually caused the stock price of potential buyer Flower Foods ( FLO ) to gain more than 30%.

Hostess, the maker of Twinkies and other snack foods, has been in bankruptcy.Liquidation seems likely and Hostess doesoffer an attractive group of brands along with a large baking and distribution network. If the brands could be bought at the right price and integrated effectively alongside Flower Foods brands, this could be a good deal. However, those are two big "ifs."

There seems to be a bidding war developing for Hostess, which could make Twinkies and the other brands more expensive than they should be. Several other large companies believe they can complete aturnaround and create profits from the brands and distribution channels developed by Hostess. Bidding wars can lead a company to pay too much and overpaying could diminish the potential profits. Because there are so many questions associated with Hostess, the profits could be difficult to obtain no matter what the buyer pays.

Given all the uncertainty, it seems difficult to explain why Flower Foods is up so much. The price is above its upper Bollinger Band on the weekly chart. We should expect to see a break of the upper Band about 2.5% of the time, so this is an indication that the recent price activity is unusual.

A classic case of "buy the rumor, sell the news" seems likely here. If Flower Foods wins a bidding war for Hostess, traders will likely sell as they consider the reality that management will need time to integrate the struggling company. If Flower Foods loses the bidding, traders will refocus on valuation and see that the stock is potentiallyovervalued .

After the recent price surge, Flower Foods is trading at more than 26 timesearnings . Analysts expect earnings growth of 3% this year and an average of about 8% over the next five years. A Hostess acquisition would change those estimates, but Flower Foods would probably have to increase their debt and face higher interest expenses in addition to business integration costs, which could lower earnings. It is difficult to see how the acquisition could grow earnings fast enough to support the lofty price-to-earnings (P/E ) ratio Flower Foods has reached.

Flower Foods is a great short trade candidate, but thedividend would make a short trade expensive since you will be liable for dividend payments on ashort sale . Put options seem like the best way to take advantage of this opportunity. After the Hostess sale is completed by the bankruptcy court, Flower Foods is likely to fall toward the lower Bollinger Band, which establishes aprice target near $18.25.

April put options with astrike price of $22.50 are trading at about $1.35. These options would be profitable if Flower Foods falls below $21.15, about 8% below the recent price. With five months toexpiration , it seems very likely that traders will reevaluate the Hostess takeover potential. If there is a sell-off in Flower Foods, these options offer a low-cost way to participate.

Action to Take --> Buy Flower Foods April 22.50 Puts at $1.50 or less. Set stop-loss at $0.50. Set price target at $3 for a potential 100% gain in five months.

This article originally appeared on TradingAuthority.com:
Traders Could Make 100% Betting Against This Potential Twinkie Savior



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Investing Ideas , Stocks

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