Thursday, June 13, 2013

The Kind of Insider Trading We Don’t Need to Worry About

The Kind of Insider Trading We Don’t Need to Worry About

Here’s the recipe for the type of insider trading that’s not a concern for the long-term wellbeing of the financial markets.

1                   1.  Set up new account shortly before the event that’s going to make you a lot of money.
2                   2.  Only trade in the stock, options, or futures of the company that you have information on.
3                   3.  Take positions that would put you at enormous risk of losing all your money but for the              fact you have inside information.

The first two steps are self-explanatory.  If out of the blue, you suddenly decide to open a brokerage account days before a merger, product announcement, bad earnings report, or another stock-moving event, that’s got to be taken as a bit unusual.  Then if you don’t buy and sell a bunch of different securities, but only trade in the company that’s got important news pending, that’s even more peculiar.

Incentive Plan (1995)
The third step is the clincher.  It would be one thing just to buy a few shares.  Let’s face it, anyone could have a hunch about a company and decide to make a small wager.  When you’ve got inside information, you’re not acting on a gut feeling.  As result, you’ll likely make a bet that has a big pay-off and appears to be very risky.

For example, you might borrow money, known as a margin loan, so you can buy much more stock than the amount of cash you transfer into the account.  Better yet, you could buy a deeply out-of-the money call option with a short-expiration date.  What does this mean? 

Suppose you had an inkling that a certain pork processor was going to be taken over.  And suppose the stock was trading at about $25 per share.  An option to purchase the stock $30 per share within the next two months would be selling for only cents on the dollar.  The option gives you the right, but not the obligation, to purchase the stock at a set price over a specific period of time.

In the absence of some big event, such as a Chinese company offering to buy the pork producer, the odds of the stock jumping 20% in two months or less are pretty low.  Thus, the price of buying the call option is low.  What happens when the pork produce receives an offer at $34 per share.  Suddenly those options are worth close to $4 per option.  In other words, you bought something for pennies a few days ago. Now it’s worth hundreds of times more.  Of course, if the deal hadn’t occurred, you would have lost all your money when the option expired (the cost of buying the options).

Instead of using options, you might have decided to buy futures.  A futures contract obligates the purchaser to buy stock at a specified price at a date in the future.  The beauty of the futures contract is that you don’t have to plunk your money down right now.  However, you have to put down a deposit of 20%.  Normally this would be a pretty risky trade, but if you know that the pork producer is going to be acquired for $34, you’d be very interested in buying lots of futures contracts to buy stock at $30 per share.  A quick four-dollar profit with only 20% down produces a great return.

The SEC caught Badin Rungruangnavarat, a Thai citizen, using this recipe in the Smithfield Foods takeover by Shuanghui International.  According to the New York Times, he made 3300% for his efforts.[1]  His ill-gotten gains have been frozen.

While Mr. Badin’s case makes great headlines, it is not the kind of insider trading that threatens the integrity of the stock market.  Blatant stupidity is easy to ferret out and prosecute.  Rather, the more damaging form of insider trading is the subtle and sophisticated form practiced by some hedge funds and proprietary traders.  Armed with lawyers, analysts, complicated analytic systems, and complex legal structures, this type of insider trading is much harder to detect and prove.  The whole idea is to obscure all three steps of the recipe, so that the trade looks like it was place in the normal course of business.

There’s no doubt that long-term investors lose when traders act on inside information.  Unfortunately, some of recipes for insider trading don’t readily reveal their ingredients.


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