INSIGHT-When options trading ahead of deals raises eyebrows

Fri Apr 12, 2013 12:59am EDT

By Angela Moon and Doris Frankel
    NEW YORK/CHICAGO, April 12 (Reuters) - Within 36 hours of
Warren Buffett's announcement of a deal to buy H.J. Heinz, U.S.
authorities froze an account linked to possible insider trading.
    The speed of the crackdown on a lucrative options bet,
combined with successful prosecutions of insider trading rings,
suggested that regulators were quickly jumping on any suspicious
activity.
     Yet some veterans of the options business are unconvinced.
They worry that very profitable options trading ahead of big
corporate news is undermining investor confidence in the
fairness of markets. 
      A study for Reuters by options research firm Schaeffer's
Investment Research of 181 such announcements in the 14 months
to the end of February shows that such activity prior to news of
takeovers, big stock repurchases or a major investment occurs on
a regular basis. 
     There were 41 examples of companies, or 23 percent of the
sample, where the volume of new call options positions -
effectively bets that the underlying stock would rise - had
risen by at least 50 percent in the five days before the news
when compared with the average of the previous six months. For
33 of these companies, the volume more than doubled.
    The U.S. Securities and Exchange Commission has announced
litigation or enforcement action for alleged insider trading
involving options trading in two of these companies - Heinz
 and Shaw Group, a nuclear power plant builder acquired
by Chicago Bridge & Iron for $3 billion. Neither Heinz
nor Chicago Bridge & Iron would comment on the trading.
    A sudden increase in bets in a particular stock does not
indicate there was any wrongdoing, as questionable trades often
have innocuous explanations. Some of the bets, while prescient,
may have been due to lucky speculation, smart analysis, or
hedging strategies rather than inside information. 
    "You can't look at an option trade in a vacuum; it could be
a hedge. The regulator has to look at what the pattern and
practice of trading was in that account," said Thomas Sporkin, a
partner at law firm BuckleySandler LLP and a former senior SEC
enforcement official.
    The SEC could also be investigating some of these instances
of "well-timed" trading, as many in the industry term it, but
have made no public announcement. It can sometimes take several
years to build a case and many probes get dropped because
insider trading is difficult to prove.
    When asked for comment, an SEC spokesman said the options
market "has been and will continue to be an area of focus,"
adding that a "simple search of the SEC website will show many,
many insider trading enforcement actions involving options." 

 
     
    Investors use call options - which give the right but not
the obligation to buy a stock at a certain price - as a way of
betting a stock will rise. Speculators often use
"out-of-the-money" call options, which mean they will expire
worthless unless the underlying stock price rises above the
strike price. If the stock surges, the options can be worth many
times their initial cost.
    For example, Heinz had been trading around $60 a share, but
an unnamed investor bet on shares rising to more than $65 each
by late June - an investment that cost about $92,000. After the
deal was announced, that bet produced a $1.7 million profit. 
    Still, without some kind of additional knowledge, many of
these call options are no better than "lottery tickets," said
Randy Frederick, managing director of active trading and
derivatives at Charles Schwab. But with inside information, it
is like knowing what the lottery numbers are before they are
announced, he said.
    Public remarks from SEC officials on the Heinz case point to
the potential for more action in the future. 
    "It may well have been the swiftest enforcement action that
we have ever filed," Sanjay Wadhwa, senior associate director of
enforcement in the SEC's New York office who was involved in the
Heinz case, said at an event in February. As global deal
activity rebounds, "I dare say you will see more of these
actions coming out of the SEC," he said.
    Options trading specialists said such trades add to concerns
there isn't a level playing field for smaller investors.
So-called "mom and pop" investors have not returned to the
equities market in large numbers after the battering they took
in the financial crisis and following market disruptions such as
the "flash crash."
    "The bigger point is the damage that is done to the
underlying confidence in our market and the perception that
things are not fair," said Ed Boyle, senior vice president of
business development and strategy at the BOX options exchange. 
    Since the beginning of 2012, the SEC has issued about 90
different releases related to litigation of insider trading, of
which 18 involve the options market. Some of those cases date
back as far as 2006. 
    Market makers, those who facilitate orderly trading by
providing the market with both buy and sell quotes on a
security, say they find themselves taking the losing side of the
bets made by those with inside information. 
    When a market maker sells a call option, they are exposing
themselves to the chance the stock will rise sharply or become
more volatile. These firms attempt to offset that risk, but
these hedging strategies won't fully cover a market maker's
exposure to extreme moves in a stock.    
    "We estimate that insider traders who use the derivatives
market end up being a very significant expense for market-making
firms like ourselves," said Jeff Shaw, head of trading at Timber
Hill, a division of Interactive Brokers Group. 
    Aside from the damage to market makers, insider trading can
force the prices of takeover deals higher - costing the
shareholders of the acquiring companies - and it can leave the
shareholders of target companies, who sold ahead of a deal
announcement feeling cheated. It can even scuttle a takeover
proposal altogether if the target gets too expensive as a result
of insider trading.
    Each of the 181 transactions that Schaeffer's studied for
Reuters had a value of at least $200 million and were revealed
publicly - through the media or a corporate announcement -
between Jan. 1, 2012 and Feb 28, 2013. Schaeffer's only looked
at new call options positions, which are the most often used to
express fresh expectations that a stock will rise, rather than
new put (bearish) positions, or already existing options
contracts.
    Schaeffer's surveyed trading on three major options
exchanges accounting for more than half of the market's
activity. The data shows that options for many big names -
including NYSE Euronext, Dollar General and US Airways - saw a
huge increase in bullish bets before major news became public
knowledge. The companies did not comment on the trading
activity.
    Of the transactions studied, 43 were excluded because there
was too little trading for meaningful analysis, 85 cases showed
the same or less trading activity, and 12 cases showed increased
activity of less than 50 percent. That left the 41 with more
than 50 percent. 
    When the ratio of trading over the five days compared with
the previous six months soars, it may raise suspicion that
information has been leaked, said Alan White, quantitative
analyst at Schaeffer's, who conducted the research.   
    The results of the study are at least partially supported by
another recent analysis by Livevol, a San Francisco-based
options analytics firm, which showed that call and put volume
rose, on average, by 71 percent and 60 percent, respectively, in
the five trading days before M&A activity was announced when
compared to the prior six months. Livevol looked at all opening
and closing options positions for 100 U.S. deals in the first
eight months of 2012.
    Some of the timing of the questionable trading looked
shrewd. 
    According to Schaeffer's, activity in new call options of
NYSE Euronext more than doubled in the five days before
it announced it had agreed to be bought for $8 billion, or
$33.12 per share, by IntercontinentalExchange (ICE) on Dec. 20,
2012.  Neither NYSE nor ICE would
comment on the trading.
    There were bets that NYSE's stock would close above $24 by
mid-January. About 9,000 calls at this strike price were bought
for about 60 cents a contract, a total cost of about $540,000.
The price of those contracts jumped to $8 each, or $7.2 million
total, when the deal was announced, for a potential profit of
about $6.6 million, said Ophir Gottlieb, managing director of
Livevol.
    In another instance, investors bet on Nov. 9, 2012 that
Titanium Metals Corp, which that day hit three-month lows of
$11.30 a share, would jump to more than $15 by late January.
Hours later, after the close of trading, Precision Castparts
 said it would buy Titanium for $16.50 a share, or $2.9
billion.  
    About 2,300 of those call options were bought that day for
10 cents each, and they rose in value to $1.50 each after the
announcement. Precision Castparts, which completed its purchase
of Titanium in November, declined to comment on the
activity. The SEC declined to say whether there was a probe into
the trading in either the NYSE or Titanium Metals.