$1.3 million lost in blatant but failed attempt at insider trading?

The blogosphere made the catch! The Interweb protects the rest of us from evil doers! The world is ablaze with the news that prior to the 3Com buyout announced by HP last week, there was an unusual amount of volume in the $5 november call in 3Com. We’re all pretty sensitised to insider trading at the moment, and so this looks as clear cut and beautiful a case of  evil-doers caught with their hands in the till as we are likely to see in our time on earth. As Tyler Durden puts it:

This is so blatant it is sufficiently stupid that even the SEC will presumably catch the perpetrator. Here’s to hoping the trader ends up being Galleon’s Raj Raj buying options from his E-Trade account while on bail. Of course, we fully expect any prosecution case against the perpetrator to fall apart at the seams courtesy of a completely inept legal team at the SEC and the Justice Department.

Oh really? Before the Zero Hedge folks get the pitchforks out, let’s stop and think a bit. Let us be splitters, and not lumpers, and we might see that would be quite reasonable for the SEC and DoJ not to prosecute anyone at all. Using the principle of Occam’s Razor, they may well tend to conclude that no insider trading took place. At least not in the options, the underlying or common may be a different matter.

Let’s get technical here. In the case of the unusual volume in the 3Com options, you should know that incredibly unusual volumes in options is not terribly unusual, if you follow me. It is in fact the case that the volume of a particular option resides, as Taleb would have it, in Extremistan. It is subject to many many days of low and limited trading, and very few days of extremely high volume, orders of magnitude above the norm, where most of the total volume traded in the life of the option takes place.  This occurs most notably in the final month of the option’s life. This is so because people are more likely to buy a particular option when its intrinsic value (the portion of the option price described by the difference of the strike and underlying prices and its volatility) is highest in proportion to its time value and its total value. This is when you get the most “bang for your buck”, as Baruch puts it — roughly 2 weeks before expiry, the option is in its prime, near its most efficient for hedging and speculative purposes.

That’s what people use options for, mostly. Hedging, and speculating. Options are excellent as a way of profiting moderately, or reducing losses, in conditions of risk and uncertainty. As a way of playing a dead cert, however, options are pretty crap. Had someone concrete knowledge of the 3Com deal, it would be far more efficient to buy the stock. The most important of the “Greeks”, as options dudes call the panoply of statistics surrounding options, is “delta”, the rate of change in the value of the option relative to the value of the shares (it’s a function of volatility, time to expiry, a whole lot of stuff, don’t trouble your head), and this is always less than one. 3Com options buyers made far less money on the takeover by buying options than they would if they had bought the stock.

Assume the 4,000 Novs and the same in Dec calls that day came from a single buyer. S/he bought an economic interest in 800,000 COMS underlying. Purchased at 65c and 85c, both calls popped post the announcement to $2.50. Hooray, a profit of $1.4m. But trading the underlying, buying at $5.611 would have given $1.52m profit. The other thing favouring the underlying as the vessel for insider speculation was that it was so much more liquid than the options. Buying 800,000 COMS would have been a drop in the lake of the volume that day, which saw 22m shares change hands. It would also have been much, much less conspicuous, and we wouldn’t even have a story. These were pretty stupid inside traders, indeed, who not just left money on the table by playing the options, but drew extra attention to themselves by doing so.

Though of course, if you want to insist on the inside trading thesis, you can always posit insiders with limited funds who couldn’t afford 800k underlying shares. So the DoJ in its inquiries should be able to exclude institutional investors. Or at least competent ones. But come on; is it the simplest explanation? Or is it actually a stretch?

Perhaps it was insider trading, but we have to posit incompetent and poor insiders for the thesis to work, and while possible this seems less likely than other explanations. A less complex interpretation for the COMS trade is that shorts, not long insiders betting on a takeover, got spooked and decided to hedge. Over 10m shares of COMS were shorted at the end of October, a proportion which might have remained stable into the takeover. Rumours fly about all the time, and 3Com has been known to be a takeover target since like forever. A 20% to 50% gap move in a big short can seriously spoil your day, if not your year, and a call position is an excellent way to hedge, to take the sting out, to make an existential 50% loss into, say, a merely unpleasant 10% one. When COMS has cancelled a roadshow, you’re seeing weirdly high volumes and a breakout, it’s actually pretty prudent for a short to hedge a bit with calls against a takeover.  

This sort of trade, moreover, happens all the time. Just this Friday, PALM November $12.50 option volume went through the roof; never mind a measly 4,000 contracts, they traded 21,000 on the day. The occasion was the the ridiculous suggestion, no doubt assiduously spread by inscrupulous holders eager to get out with some honour, that Nokia would be taking them over that weekend. The volume can probably be explained by the fact that PALM is probably the most shorted tech stock around at the moment, and more likely than not it was this lot, not numpty spanners who actually believed this crap, who bought most of the calls to cover their arses just in case. It would have been evidence of insider trading, of course, had there been an actual takeover at the end of it, and no doubt we would all be tut-tutting about the state of the markets today and how it’s all stacked against the little guy.

As it is, there wasn’t. At least there hasn’t been yet. And the owners of the options, who bought at 65c (they last traded at 23c) have until friday for the takeover to happen, after which the options will expire worthless with PALM at its current price. That will be $1.3m down the tubes. If that was money for speculation, it would have been painful for all but the biggest fund. If it was merely shorts paying up for insurance against getting their faces ripped off it would be more than bearable. You tend not, after all, really want your hedge to be making you money.

“To speculate,” the prophet said, “is human. But to hedge is divine.” The game is not just stacked against the little guy, it’s stacked against everyone, which is why some cheat. At least the little guy probably has a day job. It’s not wrong to be aware of what is probably widespread insider trading in stockmarkets today. But it’s probably very important to aim for the real evil-doers, the ones who pay executives to “get the quarter”, who know exactly what the company is going to print to the decimal point, and who have covered the tracks of their entry in a way specifically designed not to be noticed. We should get these guys, they suck, and Baruch can only applaud the FBI for the way they have handled the Galleon case. But we do need to stop and think before we throw premature accusations that may get innocent hedgers into hot water and don’t help anyone to make the game fairer.

8 responses to “$1.3 million lost in blatant but failed attempt at insider trading?

  1. Just so you are aware, the broker that executed the trades on the CBOE tried to bust them the next day. He crossed the orders with one of his other customers…and once the news of their blantant trades came about, they tried to cover their tracks. Stock Volume was almost double also…meaning the customer that sold the calls was probably buying stock 1:1 against his short position. Nice and tidy trade for both until they realized the trades were more than triple the open interest. Maybe you should get some facts before you state your opinion.

    • Sorry Chet, you’ve lost me. What are you actually saying? The market maker tried to cancel the trades as if they never happened? Is that what you mean by “bust” them? That seems a bit unfair; I would be annoyed if I had been the buyer. And what’s the relevance to the point I was trying to make?

      I would imagine whoever wrote the calls was buying stock against the position, which is, you know, fairly typical, I understand. But considering that even 1:1 hedging would only mean buying 800k common, and, again, 22m were traded, I really don’t get what you are trying to say. En-un-ci-ate, my dear Chet.

      Not personally knowing the broker, as you evidently do, or even the institution and the counterparties involved, it would be difficult for me to get “the facts”. And I haven’t stated an opinion, merely posited an alternative, slightly more probable, explanation for something people have commented on. I hardly ever have any opinions, as my friends can attest.

  2. If your cost of capital is 0%, I agree go the stock route. As I am but a humble punter of meager resources, would I not get more action via the option?

    • Pleb, assuming you are indeed one of Baruch’s more povvie readers, I can only urge you to do your insider trading using pure option premium. You will indeed get more bang for your buck on a percantage basis. But if you are even an only moderately well heeled punter you have to have an eye on the liquidity of the option, and its the absolute amount of money you can make that will interest you. Again, we’re talking 800k shares here, and buying that amount of stock at a pre-takeout price of, say, $5.60, would mean an investment of $4.5m.

      You simply wouldn’t find anyone who is going to write you $4.5m worth of premium in at the money COMS options. There is a limit to the absolute amount of money you can make with options which is limited by their liquidity. If you have lots of capital you need to make a return on, in a world free of ludic fallacies, it simply makes more sense to play the underlying stock.

      • I doubt you’d get as much attention as this trade has if you coated yourself in Vegemite and stood on Oxford Street on a Saturday night.

  3. While hardly an expert here, methinks we should consider commissions here. If this were some piss-poor attempt at insider trading, of the retail-esque variety, depending on the broker the commission on 800m shares of the underlying could be up to $100m (I sh*t you not!) I checked with a wirehouse broker, and the commission on the options trades would likely have been less than half that. Using the same hypothetical offender, would it be that hard to believe said would-be insider trader may have been more concerned about commission versus expected profits?

    I don’t necessarily disagree with your line(s) of reasoning, just saying you could apply the same Occam’s Razor type thinking to the alternative explanation, as well.

    • Dear Anal, you may be right. I really didn’t think of commissions impacting the portfolio decisions of the evil-doing inside trader. I could add that investing in options may be mostly commission-free, but the bid-offer spreads in many issues is about 5c on total premia of less than $1 per option. That would normally eat into returns, but of course if you were onto a sure thing in the COMS takeover, why would you care?

      It was 800 THOUSAND shares, by the way. Not 800 MILLION. Last I looked COMS only has about 390m shares outstanding. $100m in commission on one trade would probably make a retail broker quite happy.

      • I just checked with wirehouseesque broker, scope this mindf*ck:

        800,000 shares @ $5.60/share * wirehouse commission $0.111/share = $89,000 gross commission.

        Options: 8000 options, avg cost $0.75: $42,000 cost.

        I’m not sure what it’d look like with Interactive Brokers or someone on that level, but if its an insider, a naive one at that, chances are they could very-well be with a wirehouse.