Insider Trading & 45,000% One Day Gains
Understanding insider trading, how it is caught, and what not to do
This was an exciting week for tech with 2 IPOs (Instacart and Klaviyo) and one of the biggest software acquisitions ever. These IPOs have struggled so far but that is a topic for another day.
The other big tech news this week is that Cisco announced that it is acquiring Splunk for $28b. This is one of the largest software acquisitions ever. Because of this acquisition news and the resulting 20% jump in stock price on Thursday, one stock option trader managed to make $10m off a $22k call option the day before….and it is rightfully raising some eyebrows.
On Wednesday of this week someone bought $22K worth of Splunk call options at an exercise price of $127/share that expired on Friday. These contracts were $0.04 each on Wednesday. On Thursday the Splunk acquisition was announced and the stock price jumped 20%. These option contracts were then worth $18 overnight —a 45,650% one day gain 🤯! The $18 represents the price the stock traded at above the strike price, which was the premium Cisco is paying to acquire Splunk.
I obviously don’t know if this was insider trading, but…it is certainly suspicious that someone would buy $22,000 of deep out of the money call options that expire in 48 hours.
I actually think/hope that this is not insider trading because of how dumb and obvious it would be if it was, but either way I think the topic of insider trading is one that people should understand.
The Suspicious Trade
Insider trading often involves stock options because you can obtain a lot more leverage with much bigger payouts. If this person put $22K in Splunk stock then they would have made ~$4,400 from the 20% increase in price….not nearly as great as the $10m they made from options.
Let’s breakdown how call options work:
A call option is the right to purchase shares of a company at a certain price (i.e. “strike price”).
Call options are “in the money” if the stock price is above the strike price defined in the call option.
Call options are “out of the money” (OTM) when the stock price is below the strike price
Call options expire on a defined date. If they are “out of the money” at expiration, then they expire worthless but if they are “in the money” then the option holder profits.
The drivers of the price of a stock option are the stock price, strike price, time to expiration, volatility, and interest rates.
Stock Price & Strike Price
Yesterday when these call options were purchased, Splunk was trading at ~$120/share so the strike price was $7 above that (representing an assumed stock price increase of 6%). This means that Splunk’s stock price had to increase by at least $7 (or 6%) in order to the stock options to be in the money.
Time to Expiration and Volatility
The 6% required stock gain doesn’t seem very crazy by itself but with two days before expiration on a stock that hasn’t seen significant volatility, this trade starts to look questionable given the amount of money involved.
Catching Insider Trading
The Securities and Exchange Commission (SEC) is charged with catching illegal insider trading. They have typically done this by monitoring stock trades and tips/complaints
Trading Monitoring
The SEC has people and tools to monitor suspicious trading activities. Most illegal insider trading happens around key events (M&A, earnings reports, etc.) so increased focus is put on unusual trades shortly before these events occur. Also, many of these insider traders try to hit a home run (at least the ones that are caught) and use deep out of the money call options with short expirations which obviously raise red flags.
This is exactly what this Splunk trader did. They bought $0.04 call options that expired in 48 hours and were fairly deep out of the money so I expect it may raise some SEC flags…
This trader was either the dumbest insider trader or had the luckiest gamble ever. They were dumb if it is insider trading because it will obviously trip all sorts of red flags. The SEC will try to understand this person’s past trading activity and identify any key relationships or anything else that might be suspicious to cause them to dig deeper.
Tips & Complaints
What many people fail to understand is that call/put options are a zero-sum game. On the other side of this $10M trade was someone (or group) who lost $10M. If something smells funny to them then they will complain to the SEC. The SEC regularly receives complaints from option writers (those providing the call/put options) on contracts they wrote on a stock shortly prior to a major event being announced - like being acquired.
What is Insider Trading?
There are two types of insider trading: the illegal kind that we all hear about in news headlines and the legal kind.
Detailed rules regarding insider trading are complicated and generally, vary from country to country. What I will be covering below is how I generally understand the U.S. rules work (I’m not a lawyer…)
Legal Insider Trading
The legal insider trading happens all the time when corporate insiders buy and sell stock in their companies but follow the proper process, paperwork, and don’t hold material, non-public information at the time decisions/trades are made.
For example, public companies typically establish “blackout periods” that restrict when corporate insiders can trade the company’s securities because of the possibility that they possess insider information during those periods of time.
A common example of a blackout period is restricting employees from trading in the company’s stock for a number of weeks before the earnings announcement and they must wait a couple of days after the earnings announcement (for investors to process the new information).
An exception to the above are execs that trade stock as part of a 10b5-1 plan, which allows them to predetermine trades when they don’t have material non-public information. Example: CFO wants to sell $50K of stock on the last Wednesday of every month.
Illegal Insider Trading
Illegal Insider Trading: Refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security
Who can be guilty of insider trading?
The first rule is that there can be no insider trading without someone actually trading/profiting (buying/selling stock or options), but that person doesn’t have to be you for you to also get in trouble.
This extends beyond the companies that you have material, non-public information about. If you learn about an acquisition of a company but go and trade in a competitor’s company stock because you know how the stock will react then that is may also insider trading.
And it’s not just the person who directly profited from the trade who might be in trouble. An outsider may obtain insider information through a “tipper” or through other illegal activities (such as hacking or wiretaps).
In the case of hacking/wiretaps then just that person goes to jail and maybe the company decides to up its security.
A “tipper” though is a person who has broken their fiduciary duty and consciously reveals inside information. This person is also potentially guilty even if they didn’t make the trade.
A key part in convicting a “tipper” is that they received personal benefit from tipping about the insider information. If they receive any sort of tangible benefit then it’s easy — the person who received the information buys them a new car, gives them cash, etc. But even a personal reputation benefit of being the guy/gal who can provide great info is enough to get in trouble. So think twice about talking about this stuff to look cool…
Below are some of the likely candidates with insider information:
Board members, executives, and other employees with material, nonpublic information. Finance and accounting folks often have this info before a major event.
Employees of law, banking, brokerage, and printing firms who were given such information to provide services to the corporation whose securities they traded
Government employees who learned of such information because of their employment by the government
Friends, family members, and other “tippees” of people who had material, nonpublic information. Basically it can potentially include anyone who learns of this type of information.
What information will get me in trouble?
I tend to error on the side of caution here and don’t say anything that might even be construed as insider information, but part of that is because of my role at a company. Different people/roles have different levels of access to material information. The more you have the more cautious you need to be.
The two key terms in the SEC’s insider trading definition are: 1) material and 2) non-public.
Material information is any information that could substantially impact an investor’s decision to buy/sell a stock. A potential unannounced acquisition definitely falls into this category.
Non-public information (aka insider information) is information that is not legally available to the public.
How this “material, non-public information” gets to you is technically an important part of if you can be guilty of insider trading.
In the textbook case, it is not illegal to trade on information that someone overhears on a airplane, so long as you don’t know it is material, non-public information. Another example is that you see a public company CEO meeting with M&A lawyers at Starbucks and decide to buy the stock on hopes it will be acquired for a premium.
It’s all about whether you have reason to believe that you’re receiving important, nonpublic information from a person who has a duty to keep that information private. But if you make substantial, unusual trades it still may get you a look by the SEC…
Concluding Thoughts
I think 99.9%+ of stock trades are legitimate and on the up and up, but there are liars and cheats out there. And unfortunately many of them are probably not caught. These things can be incredibly hard to catch if it’s not too dumb of a trade.
There may be some people who may accidentally do insider trading because someone who should know better told them insider information. Ignorance is unfortunately not an excuse here, so people need to be aware of the issue. Prison time (up to 20 years) and penalties can be significant — not just for the person making the trade but the person providing the information.
Be careful with what you share and information you are using to make stock trades.
Disclaimer: This is not legal or financial advice. I am not a lawyer and the law around these rules are complex and require judgement so consult an actual lawyer if you potentially did something stupid. This post is for information purposes only.
Great find on that splunk option