Informed Options Trading prior to M&A Announcements: Insider - PowerPoint PPT Presentation

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

Motivation ◮ Unusual Options Trades before M&As ➼ 14Feb2013: H.J. Heinz by Berkshire Hathaway and 3G Capital � Market Price 13 Feb: $60.48. � Purchase of 2,533 Jun $65 OTM calls (13 Feb). � Offer Price 14 Feb: $72.50. � Total Profit: $1.8 million. ➼ 14Jan2004: Bank One Corp. by JP Morgan � Market Price 14 Jan: $45. � Purchase 2,750 Jan $47.5 OTM calls (14 Jan, 1h before announcement). � Offer Price 14 Jan: $51.77. � Total Profit: $0.825 million. More Insider Trading Cases ◮ Are these isolated cases? ◮ 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 Total Daily Options Trading Volume in Nexen Takeover Bid Total OptionsVolume (# Contracts, Calls and Puts) 40000 Deal Announcement: 23 July Unusual Trading Volume 20 July 30000 16/17 July 20000 10000 0 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 y y y y n n n n l l l l l g g u u u u u a a a a u u u u u u j j j j j m m m m j j j j 1 8 5 2 9 a a 3 0 7 4 0 0 1 2 2 5 2 6 3 0 7 0 1 1 2 0 1 0 1 2 2 SEC reacted because of suspicious stock trading! Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 3 / 50

Why do we care? ◮ SEC Enforcement Program for Insider Trading: a high priority area for the SEC . 70 60 61 58 57 50 53 50 47 46 44 40 42 37 30 20 13 12 11 9 8 10 6 4 3 2 2 0 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 Total SEC Enforcement Actions Options and M&A Enforcement Actions ◮ 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 ◮ Motivation ◮ Research Question and Hypotheses ◮ Data ◮ Empirical Analysis ◮ Informed vs. Insider Trading ◮ SEC Litigation Reports ◮ Acquirer ◮ 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? ➼ Random noise or systematic evidence of informed trading in the options market. 2. If yes, where and how do informed investors trade options? ➼ Systematic patterns? ➼ We focus on trading strategies that someone with private information could exploit to earn abnormal returns as well as the associated effects for prices and liquidity. ➼ Forensic Analysis along 3 dimensions . � Volume � Prices � Liquidity 3. How does unusual options activity relate to the characteristics of SEC litigations . Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 6 / 50

Research Design ➼ 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. � Jump in price of Target (31% premium, 16% abnormal return, on average) and volatility of Acquirer. � Assumption: Informed traders are capital constrained. � 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. � Rise in target’s stock price and flat acquirer stock price. � We can formulate clear hypotheses to accept or refute pervasive informed trading. � Target (directional) & Acquirer (Volatility). 4. Rich options data allows for the formulation of hypotheses along multiple dimensions . � Multiple strike prices. � Multiple expiration dates. Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 7 / 50

Hypotheses ... before M&A announcements ... ➼ 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. ➼ Acquirers 7. Volume increase in “jump-based” (long-gamma) trading strategies. (a) Stronger effects for CASH deals. Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 8 / 50

Literature Literature Details ◮ Insider Trading (IT) (other than by corporate insiders/EDGAR filings) ➼ Literature debates whether unusual options activity is random noise... � Poteshman (JB2006). ➼ ...or focuses primarily on stocks... � Keown and Pinkerton (JF1981), Meulbroek (JF1992), Frino et al. (IRF2013). ➼ ...or options around other events: 9/11, LBOs, specific companies... � Poteshman (JB2006), Acharya and Johnson (JFE2010), Chesney et al. (WP2011). ➼ ...or is limited in the depth and scope of the analysis. � Wang (JEB2013). ◮ Informed Trading in Options around M&A ➼ Literature focuses on information content of volume or prices for future stock returns/CARs around M&As, focusing on either the target or the acquirer. � Cao et al. (JB 2005), Chan et al. (JFQA 2013). ➼ ...or investigates the predictive power of volume/price measures for stock returns. � Hu (JFE 2013), Jin et al. (JAR 2012), Johnson and So (JFE 2011), Pan and Poteshman (RFS 2006) ... ◮ Our Contribution ➼ We document statistical anomalies consistent with trading by informed investors. � Unusual, pervasive and non-random options activity before M&A announcements. ➼ We conduct a forensic analysis of options activity ahead of M&A announcements. � Volume, Prices, Liquidity (IV, Term Structure, Skewness). ➼ We quantify randomness of unusual trading. ➼ We relate characteristics of unusual trading to SEC litigation reports. ➼ 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) � Data filters used: ➼ Acquirer seeks to own ≥ 50% ex-post, owns ≤ 50% ex-ante. ➼ Exclude pending & unknown status deals. ➼ Deal Value ≥ $1 million (exclude small deals). 2. CRSP ➼ Minimum of 90 days of stock price/volume info. for target. ➼ Keep data up to one year before and after the event. 3. OptionMetrics ➼ Jan. 1996 - Dec. 2012 = Sample Period. ➼ Minimum of 90 days of option price/volume info. for target. ➼ All options that expire after (before) the Announcement Date (iff they are ATM). ➼ Keep data up to one year before and after the event. 4. SEC Civil Litigation Reports (and DoJ Criminal Litigation Reports, under revision) ➼ All civil (criminal) litigations involving options trading and M&As. ➼ Information hand collected from SEC (DoJ) web site. 5. RavenPack News Analytics ➼ Global News Database used in quantitative and algorithmic trading. ➼ Examines over 19,000 traditional and social media sites, from Jan. 2000 - Aug. 2012 6. Thomson Reuters Insider Filings ➼ Table 2: Derivative transactions and holdings by “corporate insiders”. ➼ Examine transactions filed on Form 4 over 365 days before the announcements. 7. COMPUSTAT ➼ Detailed balance sheet used to construct propensity-matched control samples. Marti G. Subrahmanyam Informed Options Trading prior to M&A Announcements: Insider Trading? 10 / 50