Can options spikes be a coincidence?

By Felix Salmon
November 17, 2009
insider trading!

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Whenever there’s a surprise takeover bid at a significant premium to the (formerly) prevailing stock-market price, dozens of journalists and bloggers immediately pull up options-volume data. Much of the time, they discover a suspicious spike in options volume just before the deal was announced. The conclusion is obvious: insider trading!

So many thanks to Baruch for bringing a bit of context to bear on such exercises. His main points: is that options volumes are by their nature extremely lumpy. Just about any options contract, if you look at it, will have occasional extremely large spikes. As Baruch puts it, “the volume of a particular option resides in Extremistan”.

What’s more, the options markets are constantly awash in rumors, any one of which can easily cause on of these spikes. Baruch provides one example: last Friday, a rumor hit the market that Palm would be bought by Nokia. It wasn’t, but that didn’t stop 21,000 options being traded in one day on the $12.50 calls alone. That’s over five times the size of the option volume in 3Com before it was bought by HP.

And one other thing: if you did have inside information that 3Com was being bought by Nokia, you’d make more money simply buying the stock than you would buying the options. The only reason to buy the options is if you simply don’t have the cash to buy the stock.

None of which is to say that there wasn’t insider trading in 3Com, of course. It’s pretty hard to prove a negative. But statistically speaking, if you look at options volumes on every takeover bid which crosses the transom, eventually one of them is going to see this kind of spike, even if there’s no insider trading at all.


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“And one other thing: if you did have inside information that 3Com was being bought by Nokia, you’d make more money simply buying the stock than you would buying the options. The only reason to buy the options is if you simply don’t have the cash to buy the stock.”

This is just wrong.

Options let you really leverage yourself up on a takeover, which produces a much larger return for whatever stake you have.

Posted by Petey | Report as abusive

Petey is right; call options would have been far more lucrative than the underlying stock for anyone who knew the timing and price of the acquisition, because they allow a speculator to own the upside of a stock for a fraction of the cost of the shares itself. The COMS November $5 call options that the Zerohedge article highlighted as having heavy trading were available at an 80 cent ask before the acquisition announcement, and this afternoon they are bid at $2.45; that is a 206% profit. Buying the stock itself would have netted only about a 32% profit, assuming you bought on Wednesday afternoon and then sold on Thursday morning.

Posted by SeanDC | Report as abusive

The debate here is how to compare apples to oranges, and I tend to side with the commenters over Felix; compare on the basis of an equivalent amount of money tied up / put at risk, not on the basis of the number of shares underlying the options versus the stock. On the other hand, it also irks me when people suggest options are riskier than stock, and give the example of two $10,000 portfolios, one of which goes all-in on stock and the other on an option. “If you compare comparable underlyings, the option is less risky,” I’ll say. So maybe I just like being contrary. But of greater relevance, there is no single fair way to compare the return on stock versus on options; the appropriate comparison depends on context. In this case, I’m looking to maximize a portfolio return given fairly probable information on a coming stock move, and, as long as the portfolio is small compared to liquidity in the different markets, the bigger constraint is the amount of dollars that can be plowed into a position. If you’re buying options or stock under more regular circumstances, with proper diversification and so on, you probably want a delta-equivalent (or something more complicated and dynamic, depending on your exact investment goals). In this latter case, you’re probably paying a premium to protect yourself from a big downside move, as one might imagine simplistically with options; they are, in a tail-risk sense, less risky. So I think I can have my cake and eat it too.

Here\’s an example of how much better options can be for insider trading. Imagine Kraft\’s CEO goes nuts and decides to buy Pepsi. And let\’s say the takeover premium is 30%, or $80 a share.

The stock is currently at $62. If you spend $100 on stock, you end up with about $130

The $70 november calls are 5 cents each. If you spend $100, you net $20,000.

Posted by rob | Report as abusive

An off topic bike/hipster link you might enjoy

Posted by rob | Report as abusive