Traders sometimes copy the trading in options showing unusual trading activity under the assumption that someone (or some people) have privileged insight into an imminent big event or the short-term price trend for the underlying stock. Sites like Schaeffer's Investment Research dedicate a lot of ink following unusual options activity and its potential implications. Schaeffer's also provides a list of the day's options with unusual activity. Sometimes the action is so extreme - as I have written about in cases like Herbalife (HLF) and Monster Beverage Corporation (MNST) - that it seems "obvious" that the trading is based on privileged information. Yet, it is that presumption of special insight that attracts special attention to unusual trading activity. So I took special interest in reading about the SEC's recent action to move against traders who allegedly used a Goldman Sachs (GS) account in Switzerland to load up on call options one day ahead of the buyout of H.J. Heinz (HNZ) by Berkshire Hathaway and 3G Capital.
The SEC summarizes its rationale in the complaint:
The timing, size and profitability of the Defendants' trades, as well as the lack of prior history of significant trading in Heinz in the GS Account, make these trades highly suspicious. In particular, after not trading Heinz securities in the GS Account for at least six months, Defendants invested nearly $90,000 in risky option positions the day prior to the Announcement. As a result of this well-timed trade, the Defendants' Heinz position increased from approximately $90,000 to over $1.8 million, an increase of nearly 2,000% in just one day.
The traders specifically purchased 2,533 out-of-the money June $65 calls. The trading clearly shows up in the chart below:
Sudden activity in the H.J. Heinz June $65 call options
After reading the press release and the SEC complaint, here is my interpretation of what constitutes a warning sign of likely insider trading in options:
Large and "risky bets" directly ahead of the public announcement of a large stock moving event.
"Irregular and highly suspicious options trading immediately in front of a merger or acquisition announcement."
A large and outstanding gain from the trade ("highly profitable" in the SEC's words).
A sudden burst of activity in the options of a stock that has otherwise not traded with similar velocity: "Prior to the Announcement, Heinz's stock had consistently traded at just around or below $60 per share since November 2012."
A sudden appearance of large trading in options in an account that had previously not traded in that stock in at least the last 6 months.
The absence of like trades by other traders. In this case, no other trader bought the June $65 calls on the day of interest. Also, according to the SEC "The purchase of 2,533 Heinz calls with a strike price of $65 on February 13 was unusual given the historical options data for those calls. For example, on February 12, only 14 June $65 calls were purchased and on February 11, no June $65 calls were purchased. In fact, since November 14, 2012, not more than 61 of these contracts had been purchased on any other single day."
The overall open interest in the Heinz June $65 call is actually not the largest of the strikes. In particular, there is currently open interest of 4,578 contracts in the June $60 call. Interestingly, on January 24th, trading volume must have surged in these options to send open interest from around 3,000 to over 6,000 in one day. In subsequent days, the open interest apparently fell back to around 5,000. At the time, these call options cost around $2.00 each, meaning the money involved was substantially higher than the trading in the June $65 calls that have caught the SEC's attention. Also noteworthy is that at the time of the trade, HNZ had just finished a 2-week rally that sent the stock right to its all-time high.
Trading in Heinz June $60 calls sends open interest surging on January 25
Source for options trading info: eTrade.com
The trading in the June $60 call fails to meet many of the SEC's implicit and explicit criteria for generating warning flags. The SEC even makes a point of noting that the options traded were out-of-the-money; the June $60 calls were in-the-money when they traded, suggesting yet one more implicit rule. However, I find it a bit ironic that the surge in January was strong enough to attract the attention of options traders looking to ride to coattails of unusual activity.
The implication in all this action is that insider trading is hard to prove given a confluence of factors. This also reminds options traders that options trading can send signals opposite to what seems apparent on the surface. For example, when I wrote about the unusual trading in put options in Cognizant Technology (CTSH), I prepared to buy into a sell-off that never arrived. It was only after the stock broke out in the wake of positive news from an 8K filing did I belatedly realize that the traders "in the know" were the sellers, not the buyers. Accordingly, I switched my interpretation to a bullish one that turned out well. In the case of the June $60 calls for HNZ, it is entirely possible that someone assumed HNZ would not break its all-time high and decided to cover their shares by selling in-the-money calls (talk about seller's regret!). The SEC of course can gather special insights into the accounts that traded those options.
So, without the insider information of the SEC, interpreting options action will always be part art, part science. Ultimately, perhaps an even bigger lesson in the trading on HNZ is that stocks which make fresh all-time highs do so for good reasons!
A relatively orderly ascent between the March, 2009 lows and the announced acquisition
Be careful out there!
Additional disclosure: I am long CTSH call options