Informed Options Trading Prior to M&A Announcements: Insider Trading?
McGill University, Desautels Faculty of Management
New York University (NYU) – Department of Finance
New York University – Stern School of Business
May 24, 2014
We investigate 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 offers 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.
Informed Options Trading Prior to M&A Announcements: Insider Trading? – Introduction
The recent leveraged buyout announcement of H.J. Heinz Inc. by an investor group consisting of Berkshire Hathaway, controlled by Warren Buffett, and 3G Capital, a Brazilian private-equity firm, has sparked concerns about unusual option activity prior to the deal announcement.
Was this abnormal volume in the options of Heinz Inc. an indication of trading based on insider information? Apparently the US Securities and Exchange Commission (SEC) thought so, alleging that a brokerage account in Switzerland was used for illegal insider trading. Another noteworthy case from an earlier period is the merger of Bank One with JPMorgan in 2004, in which one investor was alleged to have bought deep out-of-the-money (DOTM) calls just (hours) before the announcement. While these cases received considerable publicity, they are by no means isolated cases of such activity. Indeed, while the SEC has taken action in several cases where the evidence was overwhelming, one can assume that there are many more cases that go undetected, or where the evidence is not as clear-cut, in a legal/regulatory sense.1;2 Academic research on the role of informed trading in equity options around major news events, and, in particular, the announcements of mergers and acquisitions (M&A), has been scanty.3 We aim to fill this gap with the research presented in this paper.
The objective of our study is to investigate and quantify the pervasiveness of informed trading, at least partly based on inside information, in the context of M&A activity in the US. To this end, we 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.4 We focus on the target companies in M&A transactions, but also provide some preliminary evidence pertaining to the acquirers. More specifically, we examine 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.
We show that abnormal options activity prior to M&A announcements is consistent with strategies that would a priori lead to higher abnormal returns for investors with material non-public information: abnormal options trading volume that is particularly pronounced for short-dated, out-of-the-money (OTM) call options. This activity is associated with price and liquidity changes that are expected in the presence of an unusual trading volume with greater asymmetric information: excessive implied volatility, an attenuation of the term structure of implied volatility, and an increase in bid-ask spreads. We further show that no such patterns exist for any randomly chosen announcement dates, neither in the volume, nor in the prices or liquidity. Thus, if there is no (privately) expected increase in the target’s stock price, we do not generally observe abnormal options activity that would be consistent with trading by privately informed investors.
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