Monday, October 19, 2009

Insider Trading is So 2008

Following on the heels of the arrest of Galleon Group co-founder Raj Rajaratnam, the Feds are finally threatening to crack down on insider trading. Anyone who regularly trades in the options market knows that this practice has gone on undetected and unpunished for years. Don't believe me? Here are just a few examples from the many I witnessed during my career as an options market maker:
  • A certain bio-tech stock which had fairly thinly traded options had a customer that always managed to buy out-of-the-money calls right before the company released positive phase three drug trials and FDA approvals.
  • Several really lucky options traders happened to buy a boatload of out-of-the-money calls for $.10 on a regional bank stock the day before expiration, which also happened to be the day before JP Morgan bought the bank for a huge premium.
  • My personal favorite was the purchase of loads of out-of-the-money puts in Merck for a $.05 the day before expiration, which happened to be the day before the company announced it was pulling Vioxx from the shelves. The stock dropped at least $10 on the news.
In fact, point to any M&A deal, and I'll guarantee that right before the merger is announced there is an unusually large amount of options activity. It starts with the traders who have the inside information making their bets. It is immediately followed by the piggy backers who assume that somebody knows something even if they don't so they'd better get involved. Finally, it ends with the traders who originally traded against the insider traders panicking to cover before their faces get ripped off when the actual news is announced. Is this really what we want when we talk about "efficient" markets?

Perhaps with the arrest of the billionaire Raj Rajratnam, pictured on the front page of the WSJ with Hank Paulson of all people, things will change. This particular alleged insider trading ring involved traders at hedge funds as well as executives from high-tech and health-care firms who gave them material non-public tips. The whole thing sounds like something out of the 80's but is probably far more commonplace than most of us would like to think. The ring is accused of making illegal profits of $20 million, but I'd wager it's far more than that given that Galleon was a multi-billion dollar hedge fund with decent returns. Authorities, however, only need to prove a few choice instances of insider trading to ruin the hedge fund and send the culprits to prison.

According to Bloomberg's story on the new hardline taken by Federal investigators on insider trading, the targets of the investigations, which have been going on for two years, include hedge-fund managers, lawyers and "other Wall Street players." Some probes rely on wiretaps, like the aforementioned Galleon case, while others depend on a "secret SEC commission data-mining project set up to pinpoint clusters of people who make similar well-timed stock investments." I guess the secret is now out of the bag. Who knows if any of these methods will catch another big fish? But perhaps all they need to do is scare investors into avoiding any suspicious looking activity. So next time you pick up the phone and Bud Fox tells you that "Blue horseshoe likes Andecott Steel" do yourself a favor and hang up.

No comments: