Published April 12, 2013
NEW YORK/CHICAGO – 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 January 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 December 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 November 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.
(Additional reporting by Sarah N. Lynch in Washington; Editing by David Gaffen, Dan Burns and Leslie Gevirtz)