Informed Options Trading prior to M&A Announcements: Insider Trading? Patrick Augustin · McGill University-Desautels Faculty of Management Menachem Brenner · New York University-Leonard N. Stern School of Business Marti G. Subrahmanyam · New York University-Leonard N. Stern School of Business Columbia University/Bloomberg Machine Learning in Finance Workshop New York · March 6, 2015
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Informed Options Trading prior to M&A Announcements:Insider Trading?
Patrick Augustin · McGill University-Desautels Faculty of ManagementMenachem Brenner · New York University-Leonard N. Stern School of BusinessMarti G. Subrahmanyam · New York University-Leonard N. Stern School of Business
Columbia University/Bloomberg Machine Learning in Finance Workshop
New York · March 6, 2015
Motivation
I Unusual Options Trades before M&As
ü 14Feb2013: H.J. Heinz by Berkshire Hathaway and 3G CapitalX Market Price 13 Feb: $60.48.X Purchase of 2,533 Jun $65 OTM calls (13 Feb).X Offer Price 14 Feb: $72.50.X Total Profit: $1.8 million.
ü 14Jan2004: Bank One Corp. by JP MorganX Market Price 14 Jan: $45.X Purchase 2,750 Jan $47.5 OTM calls (14 Jan, 1h before announcement).X Offer Price 14 Jan: $51.77.X Total Profit: $0.825 million.
More Insider Trading Cases
I Are these isolated cases?
I Are there many cases that go undetected?
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 2 / 50
A Striking Example: NEXEN Takeover by CNOOC
Unusual Trading Volume
Deal Announcement: 23 July
20 July
16/17 July
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Total Daily Options Trading Volume in Nexen Takeover Bid
SEC reacted because of suspicious stock trading!
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Why do we care?
I SEC Enforcement Program for Insider Trading: a high priority area for the SEC.
Total SEC Enforcement Actions Options and M&A Enforcement Actions
I We focus on insider trading in options ahead of M&As≈ 5 cases per year on average (1995-2013).
SEC Statement Definition of Insider Trading
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 4 / 50
Outline
I Motivation
I Research Question and Hypotheses
I Data
I Empirical Analysis
I Informed vs. Insider Trading
I SEC Litigation Reports
I Acquirer
I Conclusion
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 5 / 50
Research Question
1. Can we identify and quantify unusual options trading prior to M&As?
ü Random noise or systematic evidence of informed trading in the options market.
2. If yes, where and how do informed investors trade options?
ü Systematic patterns?
ü We focus on trading strategies that someone with private information could exploit toearn abnormal returns as well as the associated effects for prices and liquidity.
ü Forensic Analysis along 3 dimensions.
X VolumeX PricesX Liquidity
3. How does unusual options activity relate to the characteristics of SEC litigations.
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Research Design
ü Options trading before M&As is a useful laboratory to study informed trading.
1. M&As are the closest we can get to unexpected corporate announcements.
X Jump in price of Target (31% premium, 16% abnormal return, on average) andvolatility of Acquirer.
X Assumption: Informed traders are capital constrained.X Pre-event activity should be similar to that on random dates.
2. M&As occur frequently enough to construct a meaningful sample.
3. Nature of private information is clearly identified.
X Rise in target’s stock price and flat acquirer stock price.
X We can formulate clear hypotheses to accept or refute pervasive informed trading.
X Target (directional) & Acquirer (Volatility).
4. Rich options data allows for the formulation of hypotheses along multiple dimensions.
X Multiple strike prices.
X Multiple expiration dates.
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Hypotheses ... before M&A announcements ...
ü Targets
1. Abnormal trading volume in equity options.
2. Higher ratio of the abnormal trading volume in
(a) OTM call options compared to ATM and ITM call options.(b) ITM put options compared to ATM and OTM put options.
(c) Short-dated “front” options compared to long-dated options. Trading Strategies
3. Excess Implied Volatility.
4. Increase in %Bid-Ask Spread.
5. Increase of the (right) skewness of the option smile/skew.
6. Decrease of the term structure of implied volatility.
ü Acquirers
7. Volume increase in “jump-based” (long-gamma) trading strategies.
(a) Stronger effects for CASH deals.
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Literature Literature Details
I Insider Trading (IT) (other than by corporate insiders/EDGAR filings)
ü Literature debates whether unusual options activity is random noise...X Poteshman (JB2006).
ü ...or focuses primarily on stocks...X Keown and Pinkerton (JF1981), Meulbroek (JF1992), Frino et al. (IRF2013).
ü ...or options around other events: 9/11, LBOs, specific companies...X Poteshman (JB2006), Acharya and Johnson (JFE2010), Chesney et al. (WP2011).
ü ...or is limited in the depth and scope of the analysis.X Wang (JEB2013).
I Informed Trading in Options around M&A
ü Literature focuses on information content of volume or prices for future stockreturns/CARs around M&As, focusing on either the target or the acquirer.
X Cao et al. (JB 2005), Chan et al. (JFQA 2013).
ü ...or investigates the predictive power of volume/price measures for stock returns.X Hu (JFE 2013), Jin et al. (JAR 2012), Johnson and So (JFE 2011), Pan and Poteshman (RFS 2006) ...
I Our Contribution
ü We document statistical anomalies consistent with trading by informed investors.X Unusual, pervasive and non-random options activity before M&A announcements.
ü We conduct a forensic analysis of options activity ahead of M&A announcements.X Volume, Prices, Liquidity (IV, Term Structure, Skewness).
ü We quantify randomness of unusual trading.ü We relate characteristics of unusual trading to SEC litigation reports.ü We distinguish between informed vs. insider trading.
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 9 / 50
Data - 1,859 M&A Deals from Jan 1996 to Dec 2012
1. Thomson Reuters SDC Platinum (U.S. M&As)
X Data filters used:ü Acquirer seeks to own ≥ 50% ex-post, owns ≤ 50% ex-ante.ü Exclude pending & unknown status deals.ü Deal Value ≥ $1 million (exclude small deals).
2. CRSP
ü Minimum of 90 days of stock price/volume info. for target.ü Keep data up to one year before and after the event.
3. OptionMetrics
ü Jan. 1996 - Dec. 2012 = Sample Period.ü Minimum of 90 days of option price/volume info. for target.ü All options that expire after (before) the Announcement Date (iff they are ATM).ü Keep data up to one year before and after the event.
ü All civil (criminal) litigations involving options trading and M&As.ü Information hand collected from SEC (DoJ) web site.
5. RavenPack News Analytics
ü Global News Database used in quantitative and algorithmic trading.ü Examines over 19,000 traditional and social media sites, from Jan. 2000 - Aug. 2012
6. Thomson Reuters Insider Filings
ü Table 2: Derivative transactions and holdings by “corporate insiders”.ü Examine transactions filed on Form 4 over 365 days before the announcements.
7. COMPUSTAT
ü Detailed balance sheet used to construct propensity-matched control samples.
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Sample Characteristics
ü 1859 M&As, 1279 unique acquirers, 1669 unique targets.ü Subsample of 792: option information on targets only.
Panel A: Deal Information
Offer Structure Cash Only Shares · · · Total
Description No. % of Tot. No. % of Tot. · · · No. % of Tot.
ü Cash deals - acquisition price is clear.ü Average Deal Size is $3.8 billion. Cash deals typically smaller. Deal Size Distribution
ü Average 1-day Offer Premium is 31%.
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Options Trading Volume
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Options Trading Target - Summary Statistics
ü Higher Trading Volume in short-term and medium-term options.
ü Higher Trading Volume in OTM and ITM options.
ü Contrary to the usual pattern of ATM dominance in volume.
Target (N = 2,214,260)
DITM Mean SD Min Med p75 p90 Max
Panel A: All options, TTE = [0,30]
DOTM (3%) 246 1,973 1 20 76 300 94,177
OTM (5%) 370 1,990 1 41 164 596 88,086
ATM (79%) 273 1,291 1 40 152 531 231,204
ITM (5%) 356 6,214 1 20 80 333 539,482
DITM (5%) 275 3,264 1 10 40 171 200,000
Total (100%) 283 2,135 1 35 138 500 539,482
Panel B: All options, TTE = ]30,60]
DOTM (6%) 163 863 1 20 63 229 29,045
OTM (9%) 285 1,201 1 32 128 500 55,222
ATM (71%) 184 855 1 25 95 328 71,822
ITM (6%) 190 3,244 1 20 65 254 475,513
DITM (6%) 208 5,288 1 10 37 137 523,053
Total (100%) 194 1,787 1 23 90 316 523,053
Acquirer Statistics
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Abnormal Trading Volume - Event Study
I Event Study over the 30 days preceding M&A announcements.
I ≈ 26% of deals have abnormal volume in calls.
I ≈ 15% of deals have abnormal volume in puts.
I Abnormal volume higher for OTM calls.
I Abnormal volume for ITM Puts? - Weaker evidence.
I Abnormal volume greater for CASH than for STOCK deals. Figure Cash vs. Stock
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Abnormal Trading Volume - Event Study
I Event Study over the 30 days preceding M&A announcements.
I ≈ 26% of deals have abnormal volume in calls.
I ≈ 15% of deals have abnormal volume in puts.
I Abnormal volume higher for OTM calls.
I Abnormal volume for ITM Puts? - Weaker evidence.
I Abnormal volume greater for CASH than for STOCK deals. Figure Cash vs. Stock
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Abnormal Trading Volume - Robustness Tests
1. Different Models to predict normal returns.I Constant Mean Model, Market Model – Mean, Market Model – Median, Market Model
for Volume (MMV), Market Model for Volume with Lags (MMV-L).I Test based on raw volumes and natural log transformations.
2. Multivariate Kolmogorov-Smirnov Test. KS-Test
I Formal statistical Test of a shift in the bivariate Volume-Moneyness Distribution.I Shift stronger for short-dated options (≤ 30 days).I Shift stronger for call options.
3. Identifying the most egregious cases: Strongly Unusual Trading (SUT). SUT Analysis
ü Compare abnormal trading in SUT against Random Sample (RS).
X Zero Bid, Positive Volume, Expiration after Announcement Date, Trades within 30 daysbefore the Announcement, Front Date Option (First Expiration Month).
ü SUT Volume double than that of a matched random sample.
ü Chance that average volume in RS is larger: ≈ 3 in a trillion
4. Equity options are illiquid, there is low volume - exploit zero-volume observations.
ü Chance ≥ 1 in a million that # with positive volumes greater in pseudo-sample.
ü Zero Volume Runs
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I (Large) deals, with higher SalesI Cash dealsI Collar deals & Termination Fee (More price certainty?)
I Put options:
I Weaker evidence.
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Excess Implied Volatility - Event Study
I Event Study over the 30 days preceding M&A announcts.
I ATM (|∆ = 50|) ≈ 44% (43%) of deals have EIV in calls (puts) at 5% sign.
I ITM (|∆ = 80|) ≈ 39% (41%) of deals have EIV in calls (puts) at 5% sign.
I OTM (|∆ = 20|) ≈ 43% (36%) of deals have EIV in calls (puts) at 5% sign.I Frequency of Deals with EIV:
X higher for ATM/OTM calls than for ITM calls.
X higher for OTM calls than for OTM puts.
X lower for ITM calls than for ITM puts.
X higher for OTM calls than for ITM puts.
.01
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Call Put
Average Excess Implied Volatility
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Liquidity - Bid-Ask Spreads
I % B-A for targets widens from 35% to 55% before M&As.
I Effect stronger for (and restricted to) OTM and DOTM.
I Effect stronger for short-dated options.
.3.4
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Event Time
DOTM OTM ATM ITM DITM
Percentage Bid-Ask Spread, Target
I No such effects on randomized pseudo-event dates.
Results for IV Smile
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Liquidity - Term Structure
I Short-dated Calls/Puts become more expensive than Long-Dated Calls/Puts.
ü Slope Effect in the IV.
-.05
-.04
-.03
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elta
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IV-d
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]...,-30] [-24,-20] [-14,-10] [-4,-1] [1,5] [11,15] [21,25] [31,...[Event Time
IV-Term Calls (Mean) IV-Term Calls Random (Mean)IV-Term Puts (Mean) IV-Term Puts Random (Mean)
IV-Term Structure (91day - 30day options)
I No such effects on randomized pseudo-event dates.
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Investor Ability to Predict Takeovers?
Prob (M&A = 1) = 11+exp(−α−X β)
I Low takeover propensity scores.
I Weak explanatory power: ps.R2(%).
I Difficult to predict:
I Occurrence of Takeover.I Timing of Takeover.
Model (1) (2) (3)
Ln Assets 0.15*** 0.14*** 0.22***
WAVE 0.22*** 0.22*** 0.21***
BLOCK 0.44*** 0.43*** 0.39***
Leverage -0.10*** -0.03 -0.11***
Log Volume 0.07*** 0.07*** 0.08***
Option1 -0.78*** -0.77*** -0.70***
DivYield2 -0.05***
PPENT ratio -0.11
ROA 0.19*** 0.14***
ROE -0.02 -0.03
CumRet -0.00
RE ratio 0.10***
Q 0.00*
MarketEquity -0.00***
Ln Employees -0.03**
EPS -0.03*** -0.02***
CAPEX ratio 0.19
Constant -6.44*** -6.20*** -5.21***
Observations 121,696 119,664 101,306
LL -19,884 -19,643 -16,241
ps.R2(%) 4.35 4.46 4.70
M&A(#) 4,978 4,933 4,061
M&A(%) 4.09 4.12 4.01
M&A in sample(%) 72.83 72.46 67.78
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Speculation?
I Merger waves cluster across industries and in time.
I This may give rise to speculative trading in similar firms.
I Compare options volume in treatment and propensity-matched control group.
I Abnormal options statistically greater in treatment than in control group.
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News and Rumors?
I RavenPack News Analytics: Identify news and rumors from major newspapers,regulatory/publication relation feeds, social media sites.
I News and rumors exist for only 9% of all deals in the sample.
I Are rumors driving our results?
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Average Cumulative Abnormal Volume
I No statistical difference in abnormal options volume between the two samples!
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Legal Insider Trading?
I We examine Table 2 of the Thomson Reuters insider filings: derivativetransactions.
I SEC imposes legal requirement on registered corporate insiders (CEO, CFO, majorstakeholders ...) to report all transactions in their company’s stocks and theirderivatives.
I Result: Not a single transaction, purchase or sale, of a derivative security in the 30days before the announcement.
I We document unusual options activity – trades not initiated by legal insiders.
I Registered insiders who trade, but fail to report? – Highly unlikely as great risk ofinvestigation by the SEC.
I Could the unusual trades arise from tippees, tipped by the legal insiders? – Possibly.
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Leakage and Trading in Stocks?
I Does leakage lead to insider trading in stocks?
I Abnormal volume robust to contemporaneous and lagged stock returns.
I Only 7% of all deals in the sample have abnormal stock returns in the 30 daysbefore the announcement.
I Cumulative abnormal option volumes greater than cumulative abnormal stockvolumes.
I Marked rise in call-to-stock volume ratio, in particular in the right tail of thedistribution.
I Modest rise in call-to-put volume ratio.
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Bottom Line?
I Pervasive abnormal options activity before M&A announcts: ≈ 25% of sample.
I This is indicative of illicit activity ... but cannot be explained by:
1. Ability to predict mergers.2. Speculation.3. News and Rumors.4. Derivative trades by registered insiders.5. Leakage and trading in stocks.
I Legal Insiders: ×I Illegal Insiders: Perhaps.I Legal Outsiders: : ×I Illegal Outsiders : X
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 25 / 50
SEC Civil Litigation Reports
Characteristics of SEC Cases (Yearly Averages)
Year SEC LRs ABS Sample Illicit Profits Days to Lit. Moneyness S/K Option Mat. Days to Ann.
96-12 6 109 1,567,976 756 0.94 1 16
ü SEC Characteristics consistent with our findings: Abnormal volume in short-datedOTM call options within 30 days before announcement. Statistics by Year
ü Probability of SEC litigation larger for
I Completed deals.
I Larger deals: size, sales, offer price
I Firms with higher post-announcement abnormal returns.
I Foreign bidders.
ü Overall, abnormal volume much more pervasive than what is suggested by thenumber of SEC litigations: ≈ 5% of our sample.
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Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 29 / 50
Summary of Results
1. Directional, abnormal and non-random volume in equity options for targets aheadof M&As.
ü Effects stronger for short-dated OTM call options.
ü We quantify the randomness of these statistical anomalies.
2. Excess Implied Volatility.
3. Liquidity Effects: Price Pressure on Calls
ü Widening of B-A Spreads (OTM).ü Decrease in IV-Term Structure.
4. Evidence consistent with characteristics prosecuted by the SEC, but unusual tradingvolume more pervasive compared to number of litigation reports by SEC.
5. Preliminary evidence on acquirer: based on volatility trading.
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 30 / 50
Take-aways!
Conclusion
Our findings provide evidence of pervasive statistical anomalies consistent withinvestors trading on private information ahead of M&As.Evidence too strong to be dismissed as speculative noise.
1. Regulators
I Benefits from dedicating more scrutiny to the options market for detecting roguetrading.
I Development of forensic analytics for detection of suspicious trading .
2. Corporate America
I Corporate governance problem of leaking information. Needs to be addressed.
I Obtain trading ids for large suspicious trades prior to corporate announcements.
3. Investors
I Are financial markets fair - Level Playing Field?I Traders/Investors: Watch out for unusual options activity!
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 31 / 50
A Smoking Gun?
Thank you
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Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 33 / 50
Why do we care?
SEC Enforcement Actions: Insider Trading Cases
Insider trading continues to be a high priority area for the SEC’s enforcement program.The SEC brought 58 insider trading actions in FY 2012 against 131 individuals and entities.Over the last three years, the SEC has filed more insider trading actions (168 total)than in any three-year period in the agency’s history. These insider trading actions werefiled against nearly 400 individuals and entities with illicit profits or losses avoided totalingapproximately $600 million. Many of these actions involved financial professionals, hedgefund managers, corporate insiders, and attorneys who unlawfully traded on material non-public information, undermining the level playing field that is fundamental to the integrityand fair functioning of the capital markets.2
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SEC Definition of Insider Trading
Illegal insider trading refers generally to buying or selling a security, in breach of a fidu-ciary duty or other relationship of trust and confidence, while in possession of material,nonpublic information about the security. Insider trading violations may also include “tip-ping” such information, securities trading by the person “tipped”, and securities tradingby those who misappropriate such information.3
ü Breach of fiduciary duty is key.
ü There is a fine line between legal or illegal insider trading - we talk about statisticalanomalies.
ü Insider Trading can come from “registered” corporate insiders or outsiders.X We make no distinction in our statistical analysis: some of our cases could be by insiders who filed
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Options Strategies
ü An informed trader expects an increase in the target’s stock price and benefits from:
1. Long Bullish Strategies (+ replications)
2. Short Bearish Strategies (+ replications)
ü Strategies
1. Long OTM Call K1 (Replication: Long ITM Put K1 + Long Stock)2. Long Call Ratio Backspread (Short OTM Call K1, Long 2 OTM Calls K2 > K1)
I Replication example: Short ITM Put K1, Short Stock, Buy 2 OTM Calls K2 > K1
3. Long Bull Call Spread (Long OTM Call K1, Short OTM Call K2 > K1)I Replication example: Long OTM Call K1, Short ITM Put K2 > K1, Short Stock
4. Long Bull Put Spread (Long ITM Put K1, Short ITM Put K2 > K1)I Replication example: Long ITM Put K1, Short OTM Call K2 > K1, Long Stock
5. Short ITM Put K1 (Short OTM Call K1 + Long Stock = Covered Call)6. Short Put Ratio Backspread (Short 2 ITM Puts K1, Long ITM Put K2 > K1)
I Replication example: Short 2 ITM Puts K1, Long OTM Call K2 > K1, Long Stock
7. Short Bear Call Spread (Long OTM Call K1, Short OTM Call K2 > K1)
8. Short Bear Put Spread (Long ITM Put K1, Short ITM Put K2 > K1)
ü Conclusion: Any strategy leads to abnormal volume in OTM calls/ITM puts.
1. Could be buys or sells. ü Back to Hypotheses
2. OptionMetrics reports non-signed aggregate volume, so ok.
3. Increase in Call/Stock and Call/Put Volume, but “flat” Put/Stock Volume.
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Literature
I Insider Trading (IT) (other than by corporate insiders/EDGAR filings)ü Keown and Pinkerton (JF1981): focus on excess stock returns around M&As.ü Meulbroek (JF1992): investigates SEC prosecuted cases, focus on stocks.ü Poteshman (JB2006): unusal put volume trading before 9/11 attack.ü Acharya and Johnson (JFE2010): More insiders (syndicate) in LBOs, more IT.ü Chesney et al. (WP2011): Develop statistical tools for the detection of IT.ü Frino et al. (IRF2013): Determinants of illegal IT in stocks based on SEC litigations.ü Wang (JEB2013): Abnormal volume predicts SEC litigations.
I Informed Trading in options around M&Aü Cao et al. (JB 2005): Targets - call volume imbalance predicts future stock returns prior to
announcements.ü Chan et al. (JFQA 2013): Acquirers - IV spread (IV skew) positively (negatively) predicts CARs.ü Barraclough et al. (RFS 2012): Use options to measure synergies in M&As.ü Spyrou et al. (JFM 2011): UK evidence for abnormal volume before M&As.ü Podolski et al. (JIFMIM 2013): Regulation affects quantity of informed trading.
I Other literature ü Back to Presentation
X Where do insiders trade?ü Easley et al. (JF1998), John et al. (WP2003), Cao and Ou-Yang (RFS2009), ...
X Informational Content of Option Volume/Price for Stock Returns.ü Hu (JFE 2013), Jin et al. (JAR 2012), Driessen et al. (WP 2012), Johnson and So (JFE
2011), Pan and Poteshman (RFS 2006) ...X Price Pressure in options
ü Bollen and Whaley (JF2004) and Garleanu et al. (RFS2009)X Option Pricing Models around informational events
ü Bester et al. (WP2011), Subramanian (JF2004), Johannes (WP2006)
Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 37 / 50
Deal Size Distribution
ü Largest Cash deal: InBev - Anheuser Busch (Jun 11, 2008)
ü Largest Hybrid deal: Pfizer - Wyeth (Jan 26, 2009)
ü Largest Other deal: Comcast - MediaOne (withdrawn, Mar 22, 1999)
ü Largest Stock deal: AOL - Time Warner (Jan 10, 2000)
ü Largest Unknown deal: Hilton Hotel - ITT (withdrawn, Jan 27, 1997)
Deal Transaction Value
Offer Structure Mean Min P1 P5 P25 P50 P75 P95 P99 Max N