Three in a trillion--those are the odds average investors face in randomly buying a stock option that perfectly — and therefore profitably — coincides with an unannounced corporate merger or acquisition. Yet those types of transaction are far more common — “pervasive,” even, according to a new study, which suggests, “Informed trading is more pervasive than would be expected based on the actual number of prosecuted cases.”
Informed trading is more commonly known as insider trading, which is trading based on knowledge not available to the general public. Stock options are contracts, purchased by investors, that give them the right to buy or sell a stock at an agreed upon price in an agreed upon timeframe.
The study, by two professors from New York University's Stern School of Business and another from McGill's Desautels Faculty of Management, examined stock option activity in the context of major mergers and acquisitions. The authors chose to investigate insider trading from this perspective because it gave them an "attractive laboratory for the testing of hypotheses." In particular, the trading around unannounced mergers and acquisitions provided a meaningfully contrasting sample for the authors to test against random stock option activity. There is also a wealth of stock option data available for analysis.
The study covered more than 1,800 deals from January 1996 through the end of 2012. Most strikingly, it found evidence of insider trading in 25 percent of cases examined. The study also found that insider trading is more likely "in cases of target ﬁrms receiving cash oﬀers," the thinking behind this likely being that a cash offer is more of sure thing than a stock offer.
The authors also looked at what was being done to punish inside traders. They found that the Securities and Exchange Commission brought suit in only a very small percentage of what they considered to be obvious cases of informed trading. And they didn't hold back their criticism. "Overall, we ﬁnd that the number of civil litigations initiated by the SEC because of illicit option trading ahead of M&As seems small in light of the pervasiveness of unusual option trading that we have documented."
Perfectly timed stock option purchases aside, the study itself is also well-timed, coinciding nicely with the recent publication of Michael Lewis's Flash Boys, an indictment of Wall Street which zeroes in on inequities in the stock market caused by high-speed trading. And Brad Katsuyama, the hero of Flash Boys, gave testimony before Congress this week on the same subject. There's something in the air. The study last week was one of two publications to win an annual investor research competition by the Investor Responsibility Research Center Institute.
Despite that award, this revealing study will certainly get far less attention than Lewis's book, and will likely never be made into a movie like some of Lewis's other books. But for those who stumble across this research, it will convey a similar message: Connections count when it comes to making money on Wall Street, whether that connection is a high-speed digital pipeline that gives you a trading edge measured in microseconds or friends in high places that give you a more old-fashioned if no less effective trading edge.
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