Welcome to Baruch at Ultimi Barbarorum.* In this post, Baruch revisits the alleged, insider trading of 3Com options, casting doubt as to whether the calls were bought by persons with inside information prior to the takeover. More likely, scared shorts were trying to hedge their positions. – Ilene
$1.3 million lost in blatant but failed attempt at insider trading?
Courtesy of Ultimi Barbarorum
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.
Let’s get technical here. Do forgive Baruch if you get lost (because it may be that you’re not actually all that bright and that’s not his fault). 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 be talking about them. These were pretty stupid inside traders, clearly, 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. The easiest explanation for the COMS trade is that shorts, not long insiders betting on a takeover, got spooked and decided to hedge. 10m shares of COMS were shorted at the end of October. 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 to hedge a bit against a takeover.
This sort of thing, 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 assiduously spread, no doubt, 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. 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. 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. Over-excited accusations that may get innocent hedgers into hot water don’t help anyone to make the game fairer.
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*Ultimi Barbarorum is a tribute to the great philosopher Baruch Spinoza. From the about page:
Ultimi barbarorum is difficult to translate; English lacks a proper vocative case. We can best think of it as “O ultimate barbarians,” or “you are the greatest of barbarians”.
So, I am “Baruch”, and my dear collaborator is “Bento”. We find it hard to be so calm when confronted with the illiberal barbarities that crop up so frequently in our political, social, economic and religious life today. This is why we have started Ultimibarbarorum.com. We need a venue to rant. Like Spinoza, here we take our stand. This is our online placard. We say No More! We will expose you, horrible Barbarians. No-one is likely to care, but we will feel better about it afterwards. This is Baruch’s and Bento’s promise.
We also intend to use the site to explore Spinoza’s philosophy and ideas, and relate them to our times…
Read more here.
