A “groundbreaking” study on insider trading confirms your worst suspicions: insider trading is worse than you might imagine.

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The report shows that 30 days prior to a merger and acquisition announcement unusual option activity took place in the options markets in one out of four cases.

Insider trading before JPMoragan – Bank One merger announcement

The merger of Bank One with JPMorgan Chase & Co. (NYSE:JPM) in 2004, in which one investor was alleged to have bought deep out-of-the-money calls just hours before the announcement, is indicative of the type of insider trading activities that occur in the derivatives markets, a study from Patrick Augustin at McGill University, and Menachem Brenner and Marti G. Subrahmanyam, both from New York University, concludes. Deep out of the money call options are the prone to rise in value the most if the price un-expectantly shoots higher in price. “Although the JPM/Bank One case received a lot of attention in the press, we are puzzled as to why this case does not appear in the SEC investigation/litigation files,” the report footnotes.

“We set out to investigate whether instances of informed trading in options occur systematically or whether they were just random bets,” Augustin said in a statement. “The statistical evidence we present is consistent with informed trading strategies, and is too strong to be dismissed as just random speculation. Our findings likely will be highly useful to regulators, firms and investors in understanding where and how informed investors trade.”  Each insider trading case, on average, was worth nearly $1.6 million the study found.

Duration for a litigation action

The report not only noted the pervasiveness of insider trading, but that cases were not brought often enough. On average “it takes 756 days to publicly announce its first litigation action in a given case. Thus, assuming that the litigation releases coincide approximately with the actual initiations of investigations, it takes the SEC a bit more than two years, on average, to prosecute a rogue trade.”

After the report was published, New York Times columnist Andrew Ross Sorkin called the study “groundbreaking” and said it was likely “the most exhaustive and detailed of its kind.”  The objective of the study was to quantify the pervasiveness of insider trading in the context of M&A activity in the US. To accomplish this, researchers conduct a forensic analysis of the volume, implied volatility, and bid-ask spreads of options over the 30 days preceding the formal announcement of acquisitions. The focus was primarily on the target companies in M&A transactions, considering things such as option trading volumes (and prices and bid-ask spreads) prior to M&A announcements in the US from January 1, 1996 through December 31, 2012.