On Friday, the Securities and Exchange Commission froze assets of a Swiss account due to suspicious trades preceding public knowledge that H.J. Heinz Company (NYSE:HNZ) would be acquired by Berkshire Hathaway (NYSE:BRK.A) and 3G Capital Management LLC. The announcement from Berkshire came after the market had closed on Wednesday, February 13th and before the market opened the following day.
Heinz closed on Wednesday at a price of $60.48/share and opened the following day at $72.46/share, just below Buffett's stated price of $72.50/share, which represented a 20% premium to the market price the following day.
On February 13, the last trading day before the Announcement, one or more unknown traders, using the GS Account, purchased 2,533 out-of-the-money June $65 calls. This was effectively a wager that Heinz's stock, which had consistently traded around $60 per share for the last four months, would increase in value by approximately $5, or nearly 7.5%, over the next four months.
The chart below shows the open interest for the option contract in question. This call option contract gives the buyer a right, but not an obligation to buy Heinz stock for a price of $65/share at any time until after the expiration date. Therefore, this option contract has no exercisable value until the price of Heinz rises above $65/share and would expire worthless if the stock did not exceed that price by June.
The math for this trade is worth understanding as well:
- 2533 contracts were purchased for an average price of 36 cents per contract: a cost of $92,000
- When the market opened the following day, the exercisable value of the options became: $72.46 - $65 x 100 shares x 2533 contracts = $1.89M
- Thus overnight the value of the options increased from $92,000 to $1.89M a profit of $1.80M or roughly a twenty fold return
There are several observations that can be made from the available data. First, it is likely that the trader in question discovered that a deal was imminent at the eleventh hour. The surge in call volume activity for the contract in question began at 1:30pm EST only three and one half hours before the end of trading on the 13th of February.
Second, whoever executed the trade had knowledge of several key pieces of information. Most notably:
- They knew the deal was imminent. The short time frame of the option contract minimized the time value paid for the option, while leaving plenty of time to collect the proceeds. No one would purchase that option contract without advance knowledge of a deal. The chances of Heinz stock rising 8% in four months are otherwise unlikely.
- They were skilled in the practice of trading options. I would not have thought it possible to purchase over 2500 contracts for which the outstanding open interest was just above 300. It is surprising that the market was liquid enough to facilitate the trade.
- They knew the approximate purchase price. While I do not have historical options prices for Heinz, current option chains for similar stocks lead me to believe the trade was well optimized in terms of strike price to maximize the gain. Consider the option tree below for General Mills (NYSE:GIS).
If I had advance knowledge that General Mills would be purchased for a 20% premium to its current market price the optimum call option to buy would be 10% out of the money. I would choose to purchase $47-calls, nearly the exact corollary trade that was executed for Heinz. Thus, whoever executed the trade did not simply hear a rumor that Heinz would be acquired: it is likely that they also had knowledge of the purchase price.
The incredible aspect of this trade is how brazen it was. Buying so many call option contracts the day before a buyout announcement is a huge red flag. While the ill-gotten gains have been frozen, it will be interesting to see over the coming months if the guilty parties are ever subjected to prosecution and appropriate punishment. It is also interesting to consider the losing end of the trade. Some poor fellow sold 2533 $65 call option contracts and lost $1.8M by the time the market opened the following day. I am still surprised that the market was liquid enough to accommodate such a high burst of trading volume for this option. The counterparty in this trade may have owned 253,300 shares of Heinz to 'cover' the trade ($15.3M in market value before the announcement). However, it is also very possible that the call option was sold 'naked.' This leaves me to wonder: when trading volume on a call option spikes and you are the seller, isn't it clear your counterparty knows something that you do not? In other words: what was the seller of that call option contract thinking?
Additional disclosure: The long position for GIS refers to Jan-2015 $37 calls on the underlying stock.