Study points to the hand of insider trading in many M&A deals

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When seeking the so called “alpha”, the wealthiest investors usually prefer to hand their money over to professional asset managers, those with superior skills and expertise that empower them to take actions that the underlying client is supposedly ill equipped to do.

 As the theory goes, the “professionals” provide added value to their clients in the form of excess returns relative to the market, allowing them to justify the huge management fees they charge. Investors hand their money over to professionals because they believe these managers have expertise in generating excess returns; they frankly don’t really know (or care) about where these excess returns come from and when the going is good, it pays to turn the other cheek.

But the problem is that while in most cases returns are 100% transparent and legal (and eventually also very likely below the market), in a significant number of cases the level of excess returns obtained is an inverse function of legality – that is, the profits are mostly the result of networking between asset managers, analysts, and corporate insiders, where they exchange corporate secrets while taking drinks together. Put simply, the excess returns are the result of insider trading.

Don’t take our word for it however, as seemingly confirming the above is a research study conducted by academics at McGill and New York University (, and presented just a few days ago.

The study focused on evaluating insider trading in M&A activity by looking specifically at equity options trading in the U.S. They found that in an amazing one quarter of the deals, some kind of insider trading was evident.

The study investigated trading activity in equity options for the acquired and the acquirer prior to the announcement of the corporate merger and/or acquisition. Here is the extract reproduced:

“We investigated informed trading activity in equity options prior to the announcement of corporate mergers and acquisitions (M&A). For the target companies, we document pervasive directional options activity, consistent with strategies that would yield abnormal returns to investors with private information. This is demonstrated by positive abnormal trading volumes, excess implied volatility and higher bid-ask spreads, prior to M&A announcements. These effects are stronger for out-of-the-money (OTM) call options and subsamples of cash orders for large target firms, which typically have higher abnormal announcement returns. The probability of option volume on a random day exceeding that of our strongly unusual trading (SUT) sample is trivial – about three in a trillion. We further document a decrease in the slope of the term structure of implied volatility and an average rise in percentage bid-ask spreads, prior to the announcements. For the acquirer, we provide evidence that there is also unusual activity in volatility strategies. A study of all Securities and Exchange Commission (SEC) litigations involving options trading ahead of M&A announcements shows that the characteristics of insider trading closely resemble the patterns of pervasive and unusual option trading volume. Historically, the SEC has been more likely to investigate cases where the acquirer is headquartered outside the US, the target is relatively large, and the target has experienced substantial positive abnormal returns after the announcement.”

They conclude that the abnormal returns achieved are the result of illegal activity in at least 25% of the cases:

“Approximately 25% of all the cases in our sample have abnormal volumes that are significant…”

And, of course, managers are drawn to out-of-the-money options as these are exactly the ones that have more upside potential:

“Stratifying the results by “money-ness”, we find that there is significantly higher abnormal trading volume (both in average levels and frequencies) in OTM call options compared to at-the-money (ATM) and in-the-money (ITM) calls.”

The equity option activity starts well before the M&A announcement, leading volumes higher and pressing market makers to enlarge bid-ask spreads as they feel the added pressure even without knowing what is going on behind the scenes.

While the Feds are pushing hard to nail “Stevie” Steve Cohen and his former portfolio managers, it seems that this is just the tip of the iceberg. And we shouldn’t forget that the above study relates to the most natural and naive strategy consisting in buying OTM call options on the acquired company prior to the announcement. What about those many other more refined ways of getting the same profits while staying unnoticed? If we accounted for those, then abnormal activity would probably be a synonym for illegal. No matter what the authorities do, the seemingly “victimless” crime of insider trading will never be stamped out.

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