To make the numbers simple, imagine a stock trades at $10/share. If someone came to you and said: how much would you be willing to pay to have an option to buy the stock for $100/share? The correct answer is: it depends. If it’s the right to buy the stock for $100/share at any point over the next 10 years then that’s worth more than to buy the stock at $100/share in the next day. A stock trading at $10 is unlikely to jump to $100 in a day so the option to by it for $100 is not worth much. It could happen, so it’s worth something. But it’s unlikely. So, again to make the numbers simple, let’s say it’s worth $0.01/option to buy a stock at $100 in the next day when it’s trading at $10 today.
Now imagine it’s the next day and the company with the $10 stock discovers the cure for cancer or invents time travel or perfects cold fusion. News breaks and now it’s trading at $1,000 per share. Now how much is the right to buy the stock at $100 per share worth? The answer is going to be something really close to, but maybe a small discount from, $1,000 (current value of the stock) - $100 (how much you pay based on the option) = $900. So what was worth $0.01 yesterday is worth $900 today.
Let’s say you have $10,000 to invest. If you know in advance the news is going to break you can do two things to (probably illegally) try and profit from it.
1. Buy 1,000 shares of the stock for $10/share. 2. Buy 1,000,000 options to buy the stock for $100/share tomorrow with each option costing $0.01.
With strategy 1 you spend $10,000 to buy something that, after the news breaks, is worth $1,000,000. Not bad. But with strategy 2 you spend $10,000 to buy something that’s worth $900,000,000 after the news breaks.
In both cases you’re likely to at least be investigated. And strategy 2 seems especially suspicious because the risk is so high and the non-illegal reasons for doing it are so few and far between. Very few reasons you’d buy a bunch of call options that only pay off if something causes a stock to move dramatically in 24 hours.
Finally, while short-dated, out-of-the-money call options are not something many if anyone should be playing with, they’re just a different flavor of something very familiar. To put it in context a lot of HN readers will understand more intuitively: a call option is what you often receive when you get equity in a startup. It’s the right to purchase shares at a price (strike price) before a certain amount of time (typically 10 years).
But why are they then legal to sell? It almost seems like someone wants to be able to sell them, but when they lose the bet they want to revert it. Free money if you're on the correct side.
Things are legal until there is a law or ruling that makes them illegal
So a scenario I'm curious about:
Say you're, like, an employee at DataDog, and you're involved in a long-term M&A discussion with Cisco that you know is competitive (I've had the pleasure of witnessing one of these at Arbor Networks). Things are looking great, you've picked up a bunch of strong signals that Cisco is definitely going to make a move, and then: the talks fall apart.
Knowing Cisco, you immediately reach the logical conclusion that they're about to acquire your biggest competitor.
You have no fiduciary duty to Splunk whatsoever. Cisco is, if anything, hostile. Buying Splunk options that are valuable only if Cisco acquires doesn't impact DataDog at all.
Have you violated insider trading laws if you buy the options?
It’s less obvious with stocks because there’s a pretty streamlined system for taking delivery of the stock ownership but with physical goods or real estate sometimes actually changing ownership triggers a lot of regulatory or tax or process things.
For example, with real estate if you actually buy it you’ll need at minimum to get insurance to cover if any trespassers or workers get injured on the property. Lots of paperwork to transfer the title/deed, and you might be on the hook to help sort out future title / deed / survey errors. But if you never own it you save the headache of all these things.
For buying commodities you need a safe, regulated warehouse/tank to store it, handle all the ohysical logistics, etc.
By buying and selling the right to purchase the things you can delay the actual purchase until you find someone who can and wants to actually deal with the ownership of the thing.
If this was e.g. 1 million different buyers of 1 option each instead of 1 buyer of 1 million options this would be a non-story.
Or Matt Levine on the same case: https://archive.ph/5Dlmw
In my hypo and his, the origin of the private information I've acquired is still business my employer has conducted, so there's a better-than-baseline probability that the SEC would see this as misappropriation --- even if my employer wasn't directly going to trade on this, or if it was hard to trace any harm to my employer, it's still potentially not OK for me to profit from it.
Let's take a boring case -- that $10 stock is NOT going to $1000 tomorrow, they're not finding a cure for cancer, etc. So 99.9999999/100, if you sold someone the option for $.01, it's going to expire worthless tomorrow. You have 1M shares, you sell the call options for 1M * $.01 = $10,000.
You let some other people place bets on a thing that might (but probably won't) happen, and you get $10,000 just for owning the stock. It's like an interest payment (with some risk).
If the thing DOES happen, you are taking a risk that you'll have to sell your stock for slightly less than if you'd held it, so you're giving up some potential gains.
But in the long run, this is all priced out and balances out (in theory, in an efficient market). You get $10,000 in "interest" but are taking the risk that you might lose some upside in a black swan event, and the buyers are paying a nominal amount to take a bet on the other side. They might have spent $10k in order to possibly make a $billion -- those are risks that some people price and want to take (like a lottery).
While a hedged out of money option is commonplace. various payoffs you can create with options is mind boggling.
¯\_(ツ)_/¯
I think a lawyer would advise that that trade would come with a ton of risk. But the law isn’t clear. Generally, the SEC’s goal is to make sure markets are “fair.” What makes a market fair is hard to define.
If you do a ton of work to launch satellites to fly over Walmart parking lots and then model the correlation of how full they are to what the company’s next earnings will be: that seems like you worked hard and earned an edge you can trade on without getting in trouble. Feels like anyone has a theoretically equal opportunity to do the same work you did and get the same trading edge. That feels fair.
Your hypothetical feels less fair. Is it unfair? Maybe? So unfair that it’d be prosecuted? Probably depends on a number of things, including how much you made on the trade. At a minimum it’s an area of unsettled law. And you would almost certainly be in for serious scrutiny and a legal fight.
Supposedly one idea for Google’s business model early on was that they should use search query data to trade equities. After they researched it they concluded it would be considered insider trading. Though it’s hard to distinguish from overhearing something on the train, which (not legal advice) generally has not been. Think the difference at some level is scale and intention. And, I’d guess, if you made it your business to ride the Acela every day between Greenwich and NYC, bought special hearing aides that let you better eavesdrop on conversations, and made significant profits trading on the information then you’d be more likely to be successfully prosecuted.
But… how is that different from flying satellites over Walmart parking lots?
¯\_(ツ)_/¯
Sometimes the law is intentionally a bit unclear. Usually in areas like this where you care about a general concept of fairness and want some caution and buffer at the margins.
Presumably there's a contract between Walmart and p&g that they won't trade in each other's stocks, specifically to prevent this?
In classical insider trading, the victims are the investors in the M&A target. I'm misappropriating MNPI about the target, so I'm essentially defrauding the target's investors.
In the "shadow" case, I think it's a harder argument to make. If I work for a potential Cisco M&A target that falls through (as per the GPP), I've got, MNPI about my org, and probably MNPI relating to Cisco. Can I defraud Splunk's investors with that?
It's funny how often "we'll trade equities on the information we generate as a byproduct" comes up --- always briefly --- as a tech company business model. Like, I've non-ironically been involved in companies that had that premise, and then "real" business always swamps the "we'll trade on it" intentions.
I don't know about the law, but where I work insider trading policies also applies to vendor and supplier stocks. Trading on that info would cost me a job, at the least.
Every trade has a counterpart.
What's illegal is to use insider info to make the decision to do the trade. Did the entity making this trade use insider info? We don't know. If they did not, nothing wrong with the trade.
Now, the circumstances are such that this reeks of insider info. Nobody sane would have done that trade otherwise. So hopefully the SEC will investigate fully. If it turns out the trader really did not have any connection to either of these companies and had no knowledge of the acquisition and simply made the luckiest bet of their life.. then that's fine.
But my point is that there were people on the other side more than willing to take that person's money. If "no one sane" would do that trade, why let the other side be able to profit of it until suddenly it wasn't free money? Why shouldn't the other side carry any risk?
The seller is basically stealing money from a "sucker", until they suddenly aren't. No value in allowing those kind if bets, then. Where the seller either wins or claim fraud. Very one sided.
The only thing I would change is "perfects cold fusion" to "discovers cold fusion" :)
What else would you propose?
Designing an algorithm that prevents people from offering or taking bad trades would require a reliable crystal ball. Solving the halting problem sounds easier.