A periodic blog dedicated to providing commentary and encouraging debate on topics in Economics and Finance.

About Me

Age: 26 Occupation: Private Equity

Wednesday, July 4, 2007

What a great fourth of July Present

I was able to borrow an internet connection for this short post...

Just in case you're the one guy who thinks everything is on the up and up in the public markets... This was written before Blackstone's announcement that it was taking the Company private.

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The market looks to be positioning for volatile price action at Hilton Hotels Corp (HLT), where upwards of 32,000 lots moved today in options trading – 15 times the daily average volume for the hotel chain. While twice as many calls as puts moved today, concentrations of volume favored the July and August 35.0 straddles, and the July and August 40.0 calls.

The abrupt increase in volatility positioning indicates that the market is bracing for turbulence in Hilton shares with an uncertain, upside bias. Hilton shares gained 7 percent today to close at $36.10 in heavy trading – and with no market-moving news of note, we wonder if there' something to the chatter. Implied volatility on Hilton options soared 20 percent and currently sits at just above 38 percent – significantly above the 25 percent recorded historical volatility on Hilton shares.

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Insider trading in stocks is one thing. However, when you're knowingly trading with insider information in options, you're really ripping someone off.

That's because options involve an agreement between two parties. Let's examine...

Johnny Insider - He's the brother of an analyst at Blackstone Group. His sister - Lucy Lips, the analyst, lets the cat out of the bag that Blackstone agreed to buy Hilton at $47.50, more than $13.00 greater than the current price on the market on July 3. Johnny has $10,000 to spare, and is looking to use this information to his advantage. He has two choices - buy approximately 200 shares of Hilton, which would make him $2,600... or he could use the implied leverage of options, and make 20 times that much (you'll see how in a bit)...

Honest George - He's a market maker in options - market makers provide a valuable service... constantly offering to buy and sell shares at certain prices, giving all of us liquidity. He doesn't have any insider information, and believes that Hilton shares aren't going above $40.00 any time soon. He decides to sell the right to purchase 10,000 Hilton shares at $40.00 per share before the end of August for $1.00 per share.

He's selling a call option... As a recap, the buyer (Johnny) pays a "premium" $1.00 to the seller (George) for the right to purchase the shares at a specified price ($40.00).

Initially, Johnny pays George $10,000... which George believes to be fair compensation for the possibility that the shares will exceed $40.00, which would mean that he'd have to buy them at the higher market price and sell them to Johnny for a loss. Unfortunately, Johnny knows something George does not.

Tomorrow, Hilton's market price will skyrocket to $47.50 and Johnny will exercise his options. This means that George will have to pay $475,000 for 10,000 shares of Hilton and then sell them to Johnny for $400,000, taking a $65,000 loss (the $10,000 premium offsets some of the loss). Johnny can now sell his shares at the market price, netting a $65,000 gain(he doesn't get the premium back. As you see... the options strategy is far more profitable than simply buying shares...

Now you see how Johnny ripped George off.

George is a market maker, so it's his company's money he's losing. $65,000 doesn't seem like a big deal... but George makes tens of thousands of these transactions per day.... His trading strategy is supposed to be "market neutral"... meaning that he should make small amounts of money on each trade if the market goes either way. However, such a strategy only works when you know as much as everyone else does. George's exposure to loss may have reached into the millions before he got wise, costing the investors in his company (Average joes who invest in Goldman, Interactive Brokers Group, etc.) tons of money and putting his job in jeopardy.

I hope the SEC finds every one of the "Johnny's" out there. We all deserve a level field when we're trading in the markets.

- eternitus

2 comments:

dxm113 said...

interesting stuff. . .

As a Financial Analyst, do you see insider trading and / or its effects often?

Do you think that the average investor is oblivious to a widespread insider trading problem?

eternitus said...

dxm,
I think most people presume that it doesn't happen, and that there are grave consequences for anyone who partakes in the activity....

However, several pieces of research have indicated huge spikes in options volume just prior to takeover announcements (Dow Jones, Hilton, and many others).

Given the size of the Companies involved and the size of the deal teams... there's a lot of info to go through in an LBO... my guess is insiders feel more comfortable that they won't be singled out if someone comes asking questions... safety in numbers.

Unfortunately, the SEC only catches a fraction of the perpetrators... partly because its so difficult to determine whether someone actually got a tip or got lucky... Unless the person in question normally trades in increments less than $1,000 and all of a sudden plows $10,000 into Hilton on Tuesday.

Insider trading is obviously rampant... the only way to put a stop to it is to enforce the laws in place, and make the penalties severe enough to seriously limit the practice.

I, for one, filed a complaint with the SEC yesterday. I own a stock (IBKR) that does market making in options(as Honest George does in my recent post), giving me a vested interest in stopping the practice as it harms my firm's profitability.