September 5, 2014
By: Jon Gold, Director, Senior Consultant
What makes options such an appealing vehicle for trading on insider information? Their innate leverage and breadth of securities are desirable attributes, particularly in concert. If the expectation is a price rise, then a position in call options can produce far greater percentage returns. This characteristic would naturally benefit any trader with a decided bias, legitimately formed or otherwise. Relative to trading a single stock, there are myriad options with varying strike prices and expirations. Taken together, smaller individual positions spread around a few carefully chosen options has the potential to achieve the desired results.
A classic whitewash? Clorox (CLX) options have remained under scrutinysince a hostile takeover bid was launched in July 2011. Even the option trades of professional golfer Phil Mickelson were investigated. (He was ultimately cleared.) Of course, the spotlight was not shone on CLX until after the bid, at least not publically. The clues, nonetheless, were there. Luckily, as compliance officers, you will likely face a much smaller pool of option transactions to scrutinize than, for example, a regulator or a financial journalist in search of a scoop. Unluckily, you’d prefer to accomplish this prior to the market moving event.
Options, unlike (most) stocks, expire: Absent a lengthy discussion of option price sensitivities, the longer the life of an option, the more it costs (all else held equal). The goal of any option buyer aiming to maximize their return on a successful bet is to buy no more time than they deem necessary. Therefore, a sudden concentration of activity in a particular near-term expiration may be a clue. The activity in CLX centered on call options with less than a week until expiration. The takeover bid occurred that same week.
Three strikes, you’re in: The choice of strike price, the price at which the option allows its holder to buy (call) or sell (put) the stock in question until expiry, is a critical strategic component. For calls of a particular expiration, higher strikes mean lower cost, hence higher potential leverage. Remember that the underlying stock need not reach the strike price to generate leverage. It just needs to move sufficiently toward it. This is not to say that all calls will rise in value, particularly near term expirations, but strike prices higher than current market prices that are within a few strikes of the stock’s current market value are viable candidates. The spike in CLX July call options involved 3 strikes at and above the stock price, as Table 1 below summarizes.
Call ahead: Get a better feel for these dynamics by experimenting with stock price, strike price and expiration terms inputs to an option calculator. For now, let’s work with the presumption that short-duration options with strike prices at or slightly out of the money are our targets. Unfortunately, that hardly constitutes a ‘smoking gun’.What other conditions might be indicative of an unusually keen market insight?
Market implications: Another clue are spikes in an option’s implied volatility, the volatility of the underlying stock implied by an option’s market price. The practical use in this context is that it affords a way to measure the ‘price’ of an option as time passes and stock prices fluctuate. Simply put, if implied volatility rises, the option has gotten more expensive irrespective of the direction of changes to its dollar price. Table 1 depicts the spike in implied volatility which occurred on July 11.
Watching the volume with interest: Option volumes and open interest are also indicators. Listed option transactions are reported, so their volume may be observed daily. Open interest increases when a new listed option position is established (long or short). Quiet options which fit the ‘profile’ and which suddenly experience spikes in volume and a change in open interest might attract one’s attention. Current day volumes are easy to glean on the day a trade is made. Open interest is published the following morning. It is a bit more challenging to go backward in time in order to see how active that option has been, but the historical data is available and your firm may already have access to it via existing data services.
Big gulp: Nearly 8,000 CLX calls expiring in four days changed hands on Monday 7/11. Most had strikes between $70 and $75, following a $68.12 close. Table 1 shows that barely 200 had traded the entire preceding week. Open interest on the $70 strike rose by nearly 50%and nearly doubled on the $72.50’s. By the 13th, the volume had abated and CLX settled back to the high $60’s.
The gun smokes: A $76.50 per share bid was announced on Friday July 15. That was last trading day for these July options. Shares closed at $74.50.
Chicken or egg? A moving stock price may reflect, rather than explain option activity. Sellers of calls, for example, are likely to purchase the underlying stock in order to hedge their position, particularly if call buyers dominate, and that would drive stock prices higher.
Insider trading, if it indeed occurred in the CLX case, is not typically this readily identified. However, if you were to see this pattern occur at your firm, you’d be better equipped to home in on suspicious activity and ask those probing questions.
* Open interest statistics have been moved forward one day to align with the volume of that day. Green (rises) indicates new positions; red (declines) indicates positions being closed.