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
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?
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.