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Monday, August 28, 2006

Insider Trading (and Options) Around Takeovers

Gretchen Morgenstern (of the NY Times) has written about suspicious trading patterns around mergers. She notes a study by conducted for the NYT by Measuredmarkets Inc., who looked at all $1 billion plus-sized mergers announced in the 12-month period that ended in early July. The study found:
the securities of 41 percent of the companies receiving buyout bids exhibited abnormal and suspicious trading in the days and weeks before those deals became public. For those who bought shares during these periods of unusual trading, quick gains of as much as 40 percent were possible.

Although any number of factors can lead to spikes in trading, deviations of the kind observed by Measuredmarkets are among the data used by regulators to spot insider trading. Of the 90 big mergers in the period, shares of 37 target companies exhibited abnormal trading in the days and weeks before the deals were disclosed.
MeasuredMarkets tried to make sure that the increased trading wasn't due to other factors like merger talk in the media or announcements by the companies involved.

You can read the NYT piece here.

But Morgenstern missed a much more interesting story about trading around mergers. If insiders had information they wanted to trade on, they'd be much better off trading in the options markets rather than the stock market.

Arnold, Erwin, Nail and Bos have a paper on this topic on SSRN titled "Speculation or Inside Information: Informed Trading in Options Markets Preceding Tender Offer Announcements." They find pretty good evidence that insiders do exactly that. Here's the abstract:
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
You can read the whole thing here.

In her article, Morgenstern noted that "For those who bought shares during these periods of unusual trading, quick gains of as much as 40 percent were possible." As Crododile Dundee would have said, "that's not a return! -- THIS is a return!" In the Arnold et. al. paper, some of the options trades resulted in profits of over 3,000 percent.

All in all, and interesting topic and a very interesting paper.

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