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Saturday, February 26, 2005

Options Trading Around Takeovers

Almost every week, I see a news article about unusual option trading volume for a company that's subject to a takeover rumor. A good number of studies have examined informed trading around takeovers. While some have examined whether informed trading takes place by looking at legal insider trading (from SEC form 3 and 4 filings), a better strategy for informed traders would be to use the options market. The Financial Accounting Blog highlights another example of takeover-related unusual options volume with this story from MSNBC about options trading around the takeover of Gillette by P&G:

Well before the investing public learned of the $57 billion takeover of Gillette by Procter & Gamble, traders apparently got wind of the deal: Options-trading volume in both companies spiked more than fourfold on Jan. 27, before news of the marriage was announced.

The action, which led to one-day profits of more than 500% on some of those trades, has raised more than a few eyebrows on Wall Street.
One interesting question is whether the increased trading comes from speculators who got wind of the transaction (the "word on the street") or from corporate insiders who had more specific knowledge of the deal terms. If it's the first, traders would simply buy long-term at the money options. If it's the second, their knowledge of the deal terms would allow them to select the option contract that would allow them maximum profits from using their private knowledge. Arnold, Nail, and Bos (2000) have a paper on the SSRN, Speculation or Insider Trading: Informed Trading In Options Markets Preceding Tender Offer Announcements that examines this very issue:

In our sample of 305 cash tender offers occurring between 1993 and 1998, we find evidence that the options market has become the preferred trading venue for informed traders. Given this result, we analyze individual call option contracts for those tender offer targets with traded options, identifying the one optimal insider contract which maximizes the returns to insiders with perfect knowledge of a pending tender offer. This analysis allows us to test the competing market anticipation and insider trading theories of pre-bid stock price and volume run-ups using the trading patterns of options which should be preferred by insiders and those preferred by speculators. Our individual contract analysis is consistent with both theories as we find trading in both insider-preferred and speculator-preferred contracts drives aggregate call option volume run-ups. However, heavy trading in the optimal insider contract occurs on heavy volume days for all contracts. These results support the notion of Easley, O'Hara, and Srinivas (1998) that a substitution effect exists whereby informed traders prefer to trade in options markets when possible and that insiders will hide their trades within those of speculators.

Suggested Citation
Arnold, Tom, Erwin, Gayle R., Nail, Lance A. and Bos, Ted, "Speculation or Insider Trading: Informed Trading in Options Markets Preceding Tender Offer Announcements" (May 2000). http://ssrn.com/abstract=234797

It's worth a read. Based on their data, profits like those mentioned in the MSNBC article aren't unusual - the mean return on call option purchases over the tender offer period is 455% (over 14 times the average profits on insider stock purchases).

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