M & A Law Prof Blog

Editor: Brian JM Quinn
Boston College Law School

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Tuesday, June 17, 2014

Equity options and insider trading

I am shocked! Shocked that there is insider trading in advance of merger announcements! OK, so I'm not.  But, what is surprising is just how much of that insider trading happens via equity options.  Seriously.  I know you can make a lot of money in equity options, but you're also going to get caught.  Anyway, there is a new study by Augustin, Brenner and Subramanian, Informed Options Trading Prior to M&A Announcements: Insider Trading?  I think that's a rhetorical question.  Here's the abstract: 

Abstract: We investigate informed trading activity in equity options prior to the announcement of corporate mergers and acquisitions (M&A). For the target companies, we document pervasive directional options activity, consistent with strategies that would yield abnormal returns to investors with private information. This is demonstrated by positive abnormal trading volumes, excess implied volatility and higher bid-ask spreads, prior to M&A announcements. These effects are stronger for out-of-the-money (OTM) call options and subsamples of cash offers for large target firrms, which typically have higher abnormal announcement returns. The probability of option volume on a random day exceeding that of our strongly unusual trading (SUT) sample is trivial - about three in a trillion. We further document a decrease in the slope of the term structure of implied volatility and an average rise in percentage bid-ask spreads, prior to the announcements. For the acquirer, we provide evidence that there is also unusual activity in volatility strategies. A study of all Securities and Exchange Commission (SEC) litigations involving options trading ahead of M&A announcements shows that the characteristics of insider trading closely resemble the patterns of pervasive and unusual option trading volume. Historically, the SEC has been more likely to investigate cases where the acquirer is headquartered outside the US, the target is relatively large, and the target has experienced substantial positive abnormal returns after the announcement.

Three in a trillion?  Those are pretty long odds.  You'd be better off buying a lottery ticket than replicating the results they find here in the absence of material inside information ... a lottery ticket! It's odd, because it's so dumb of the traders, but the authors find that in the run-up to an announcement of a merger, there is increased abnormal trading volume in single equity options of the target.  If it's not obvious, that means if you are in possession of material non-public information and you are trading in single equity options prior to a merger announcement, you might as call the SEC and tell them to arrest you.

-bjmq

 

 

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