As if the market needed any further proof it is not only manipulated and rigged (at least under a legal system that classifies trading on insider information as illegal), but is constantly abused by those with material, non-public information - i.e., insiders - here comes a study conducted by professors at McGill and New York Universities, which, as the NYT summarizes, finds that "A quarter of all public company deals may involve some kind of insider trading."
Here we would add 'at least' because what the study's authors have not looked at are other derivative products like CDS - and especially 2s/7s steepeners ahead of LBOs - which, like OTM equity calls, provide just as material returns when traded ahead of a transformational announcement, and which, unlike equity, are so far below the SEC's radar, virtually all sophisticated money manager use credit default swaps as their preferred method of trading on illegal information.
And now, back to the Efficient Market Hypothesis.
From the study's abstract:
We investigate informed trading activity in equity options prior to the announcement of corporate mergers and acquisitions (M&A). For the target companies, we document pervasive directional options activity, consistent with strategies that would yield abnormal returns to investors with private information. This is demonstrated by positive abnormal trading volumes, excess implied volatility and higher bid-ask spreads, prior to M&A announcements. These effects are stronger for out-of-the-money (OTM) call options and subsamples of cash orders for large target firms, which typically have higher abnormal announcement returns. The probability of option volume on a random day exceeding that of our strongly unusual trading (SUT) sample is trivial - about three in a trillion. We further document a decrease in the slope of the term structure of implied volatility and an average rise in percentage bid-ask spreads, prior to the announcements. For the acquirer, we provide evidence that there is also unusual activity in volatility strategies. A study of all Securities and Exchange Commission (SEC) litigations involving options trading ahead of M&A announcements shows that the characteristics of insider trading closely resemble the patterns of pervasive and unusual option trading volume. Historically, the SEC has been more likely to investigate cases where the acquirer is headquartered outside the US, the target is relatively large, and the target has experienced substantial positive abnormal returns after the announcement.
And some more:
We document evidence of a statistically signicant average abnormal trading volume in equity options written on the target rms in the US over the 30 days preceding M&A announcements. Approximately 25% of all the cases in our sample have abnormal volumes that are significant at the 5% level, and for 15% the significance is at a 1% level. The proportion of cases with abnormal volumes is relatively higher for call options (26%) than for put options (15%). Stratifying the results by "moneyness", we find that there is signicantly higher abnormal trading volume (both in average levels and frequencies) in OTM call options compared to at-the-money (ATM) and in-the-money (ITM) calls. We also find that ITM puts, as well as OTM puts, trade in larger volumes than ATM puts. This is strong evidence that informed traders may not only engage in OTM call transactions, but possibly also ITM put transactions. In addition to evidence of abnormal trading volumes in anticipation of M&A announcements, we provide statistical evidence that the two-dimensional volume-moneyness distribution shifts signicantly, to OTM call options with higher strike prices, over the 30 days prior to the announcement day.
For once we agree with the NYT's Andrew Ross Sorkin, even though he doesn't actually present an opinion but merely concludes that "the results are persuasive and disturbing, suggesting that law enforcement is woefully behind — or perhaps is so overwhelmed that it simply looks for the most egregious examples of insider trading, or for prominent targets who can attract headlines."
There is much more in the full study (link), but here are is some of the pretty charts that back the findings:
Figure 1 illustrates the daily average option trading volume around the M&A announcement, from 60 days before to 60 days after the announcement date. Figures (1a) and (1b) plot the average call trading volume for, respectively, the acquirer and the target. Figures (1c) and (1d) plot the average put trading volume for, respectively, the acquirer and the target. The bars represent the average daily trading volume across all M&A deals, where for each deal, the daily volume reflects the total aggregated volume across all traded options. Volume is dened as the number of option contracts. Source: OptionMetrics.
Figure (2a) plots the average abnormal trading volume for, respectively, all equity options (solid line), call options (dashed line) and put options (dotted line), over the 30 days preceding the announcement date. Volume is defined as the number of option contracts. Figure (2b) reflects the average cumulative abnormal trading volume for all options (solid line), call options (dashed line) and put options (dotted line) over the same event period. Figures (2c) and (2d) plot the average abnormal and cumulative abnormal trading volume for call options in M&A transactions that are either cash-financed (solid line) or stock-financed (dashed line), over the 30 days preceding the announcement date. Source: OptionMetrics.
And the punchline: Figure 5 plots, for the target companies, the average excess implied volatility relative to the VIX index for the 30-day at-the-money (ATM) implied volatility from, respectively, call (dashed line) and put (solid line) options, over the 30 days preceding the announcement date. Source: OptionMetrics.
And now, BTFATH in this "unrigged" market in which the sucker is, well, you.