Whenever I hear about merger and acquisition deals, or even just a big piece of market moving news, I, like so many other people, take a look at the chart. It seems almost uncanny how many times the stock started moving in the days before, albeit a big board or a microcap stock. Well, if it’s any consolation for those who thought something was suspicious, professors at New York University and McGill University in Montreal, Canada thought so too.
New Study Could Indicate Widespread Insider Trading
Professors at the two universities decided not to take not a look at common stock trading, but rather at option activity, which can yield far, far greater returns than buying shares in the open market. Because of leverage, it’s not uncommon for overnight gains on big news to run well into triple-digit percentages, or even in excess of 1,000 percent if the trade is bought before the news hits the wires.
The study covered equity option activity before merger and acquisition announcements from January 1, 1996 through December 31, 2012. The conclusion was that 25 percent of the deals showed unusual activity in options happening in the month before the deals were made public.
Think maybe it was just coincidence that option activity increased? The researcher say to think again. The professors said that the odds are about 3 in 1,000,000,000,000 that it was coincidental. The research also concluded that activity increased in out-of-the-money call options of cash offers for large target firms. Cash deals typically result in a bigger price jump for the company being acquired.
Options Trading Before News Unlikely to be Coinicidental
One of the academic points forming a cornerstone of the study was the unexpected nature of merger and acquisition news. “For one thing, M&A announcements are publicly unexpected events, in terms of timing and even occurrence. Thus, on average, we should not be able to distinguish options trading activity before an announcement from that occurring on any randomly chosen date,” the researchers said in the 81-page published study.
The study is a lot to swallow, but chocked full of information, including the perhaps unexpected conclusion that there is often unusual activity in trading of the acquiring company. The best way to play an acquiring stock, should one choose to illegally make moves with insider knowledge, is to aim for non-directional volatility, which is what the professors discerned that informed traders were often doing.
The study also noted that very little research has been done in this area and that the Securities and Exchange Commission only looks into a small minority, about 4.7 percent, of the 1,859 M&A deals that were included in the sample. That’s not a knock on the SEC, as the investigations are long and intensive for an agency that is too far undermanned to try and succinctly scrutinize every M&A transaction.
It is notable that a study by Schaeffer’s Investment Research last year looked at a smaller sample of 181 acquisitions and concluded similar results of about one-in-four acquisitions accompanied by unusual options activity ahead of the announcement.
Insider Trading the Only Explanation?
But, is it really all insider trading? That is certainly a topic for debate. There are always leaks of information; there’s no denying that. The bigger the deal, the more advisors, consultants, lawyers, etc. involved and the more chances there are for slips of information. Just take a look at how many times financial websites, such as the Wall Street Journal, cite “sources close to the matter” that a deal is in the works or about done a day before the news is delivered. Option trades, especially when properly managed, are harder for the SEC to detect than common stock and out-of-the-money calls; there’s no denying that either.
But, to say that all of the “abnormal activity” is insiders jumping in and risking being busted to make a quick, massive profit isn’t likely the absolute answer. A more palatable answer is founded on the idea that buying begets buying on Wall Street and there can be a number of catalysts that start the ball rolling. Investors making educated guesses about acquisition targets, analyst commentary or buying on an uninformed rumor that moves the volatility needle and attracts attention are all possible culprits in getting some buying going.
Then again, the wick could also lit by someone making a move on insider information. Everyone knows it goes on, but to what degree will be a conversation for the ages.
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