Are Options Used to Cheat on Takeovers Using Insider information? Yeah, I think so... But Let me Prove it.

This is a slightly different type of post than I normally write. Let me know what you think about it by sending an e-mailto support@livevol.com. If you like it, I'll try to do more like this... otherwise I'll stick to vol stories on specific stocks.

Here's my conclusion up-front:
In my opinion, the use of options to garner unfair (read: illegal) financial gains through the use of private/insider information is a legitimate phenomenon that is identifiable on a case-by-case basis (read three articles included below as heuristic examples), as well as in a broader analysis.


Bottom line, yeah, the cheaters are using options. Or so I think...


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Livevol did a study -- or really an "analysis" -- of option trading trends before a takeover is announced and compared those trends to the six months prior to the takeover announcement. The idea was actually inspired by Reuters (and one of their immensely talented writers, Doris Frankel) which came to us with the intriguing question, "does the option market reflect the potential misuse of insider information prior to takeovers?"

While answering that question is a bit ambiguous (see analysis below), IMHO, yes, there is a trend, and yes, there are cheaters. A lot of them. Now that doesn't come as a surprise to most of you reading the blog - somehow I have turned into the lightning rod for opinions on insider trading, but let's look at data rather than opinions (even though my opinions are much more fun!)

The Set-up:
1. We looked at the top 100 takeovers from Jan 1 2012 to Aug 2012.

2. We looked at the average option volume (puts and calls separately) for the six-months prior to the takeover stopping five-days prior to the announcement.
e.g. Takeover Date Jun 7, we looked at average option volume from Jan 1 - Jun 1.

3. We then compared #2 with the average option volume five days prior to the takeover (continuing the example above, we looked at the average option volume Jun 2- Jun 6).

To add a little flavor to the mundane number crunching, I have posted several articles in specific that dealt with highly suspicious option trading prior to a takeover. I have included just a few of those below for reference below (and I do mean, "just a few" of the ones I have written):

2-14-2013
HJ Heinz (HNZ) - Takeover and a Cheater? Maybe...

12-20-2012
NYSE Euronext (NYX) -- Unusual Trading in NYX Takeover and Potential Hidden Trades

9-27-2010
AirTran (AAI) - Lucky Bet or Cheater in Takeover?

The Results


We can see:
1. On average option volume increased 67% in the five days prior to a takeover when compared to the six-months prior.

2. On average call option volume increased 71% in the five days prior to a takeover when compared to the six-months prior.

3. On average put option volume increased 60% in the five days prior to a takeover when compared to the six-months prior.

Pretty compelling evidence... But, we can also see that the standard deviation of the daily average option volumes was about 2x higher surrounding the takeover.

In English, option volume was much higher and the volatility of volume was much higher in the five days surrounding a takeover. For you Stats 101 guys, yes, this would fail a test for significance, but this is finance -- tests of significance aren't necessarily the point...

OK, so what is the point? In my opinion, the use of options to garner unfair (read: illegal) financial gains through the use of private/insider information is a legitimate phenomenon that is identifiable on a case-by-case basis (read those three articles for example), as well as in a broader analysis.

Bottom line, yeah, the cheaters are using options. Or so I think...

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