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We investigate the prevalence of informed options trading prior to takeover announcements, when the legal prohibition against insider trading is strictest. Although insider trading laws apply equally to the options and stock markets, the options market is considerably more transparent than the equity market, which makes insider trading in options more easily detectable. We find that privately informed investors trade in the options market prior to takeover announcements; however, their transactions are limited to liquid call options and options with high inherent leverage. Furthermore, we find that prior to takeover announcements, informed investors trade on their private information in the options market only when a SEC investigation of insider trading is unlikely to occur. Our results suggest that even prior to takeover announcements informed investors are attracted to the options market, which increases profit making potential due the greater leverage it affords, although they trade in a way which minimizes the likelihood of detection.

Takeover announcements are associated with considerable increases in target firm share prices and offer highly profitable opportunities to privately informed investors. Indeed, Meulbroek (1992) finds that roughly 80% of insider trading cases prosecuted by the SEC during 1980–1989 were takeover related. Informed investors can profit from their private information by either buying the target firms shares or call options prior to takeovers being publicly announced. The options market with its embedded leverage and lower transaction costs offers investors greater profit making possibilities, but at the same time increases the likelihood of their transactions being detected due to lower anonymity. Given the offsetting incentives for trading in the options market, a central question addressed in this paper is whether informed option trading is prevalent prior to takeover announcements. Examining the information content of option prices prior to takeovers announcements is unique as virtually all private information impounded into security prices can be deemed illegal given that SEC Rule 14e-3 prohibits exploiting any informational advantage relating to takeovers.1 Despite trading on private information attracting the same legal sanctions in both markets,2 insider trading is more easily detectable in the options market and therefore riskier for insiders.3 For example, Lee and Yi (2001) show that large trades on the CBOE are not anonymous, which allows options market makers and regulators to screen informed investors more effectively.4Dolgopolov (2010) argues that options market makers stand to suffer higher losses when trading against insiders relative to their counterparts in the equity market, and therefore have a greater incentive to detect and report insider trading.5 This legal environment is expected to affect informed trading in the options market. We propose and test two main hypotheses. First, we hypothesize that informed investors trade options prior to takeover announcements due to the greater profit making ability. Nevertheless, we expect that informed investors will gravitate to liquid options which increase the ability to camouflage one's transactions (and avoid detection). Similarly, options which offer greater leverage are expected to attract more informed investors. Second, we hypothesize that informed trading is less likely to occur in the option market when a Security and Exchange Commission (SEC) investigation into insider trading subsequent to the takeover announcement is perceived to be higher. We examine takeover announcements over the period between January 1996 and December 2008 and concentrate on the pre-announcement option trading activity of publicly traded takeover targets. Consistent with Roll et al. (2010) we first develop a simple empirical construct, the options-to-stock trading volume ratio (O/S) in the pre-announcement period. O/S is the average ratio in the seven day period preceding takeover announcements between the total volume of trading on the listed options market and the corresponding volume of trading on the stock market. The component of O/S is measured separately in dollars and shares. We find that O/S increases in the pre-announcement period relative to the non-announcement period, which suggests that informed investors tend to gravitate to the options market prior to takeover announcements. This is somewhat surprising given the greater probability of detection in the options market. We further find that there is more options trading volume in the pre-announcement period for options with high liquidity and leverage. There are also less options trading volume in the pre-announcement period for options with wide spreads. We conclude that liquidity, leverage, and transaction cost is associated with the extent of informed trading in the options market. Next we measure the information content embedded in call option prices in the pre-announcement period by measuring the portion of the takeover premium explained by changes in options prices in the pre-announcement period.6 We find that in aggregate, changes in call option prices in the pre-announcement period do not explain any portion of the takeover premium. However, the explanatory power of changes in call option prices increases substantially with option leverage and liquidity. These results show that informed investors will only take the risk of trading in the options market on their private information when leverage is high (leverage increases expected profit potential) and when liquidity is sufficiently large (liquidity increases anonymity). In the final avenue of inquiry, we examine how the threat of a SEC investigation into insider trading affects the prevalence of option trading prior to takeover announcements. Examining what effect the risk of being detected by the SEC has on insiders’ preferred trading venue is complicated by the fact that we cannot directly observe the methods used by the SEC to find illegal insiders. We deal with this problem running logit regressions model which identify the factors which increase the likelihood of a SEC investigation. Our logit regression results reveal that the single most robust factor which increases the chances that the SEC will investigate for insider trading deal value, with the likelihood being larger for large deals. By partitioning our sample on deal size, we find that the increase in O/S in the pre-announcement period is most pronounced for small deals which are less likely to be investigated for insider trading. We also find that the cross-sectional pre-announcement O/S decreases with deal size. Finally, we find that changes in liquid call option prices in the pre-announcement period explain a large portion of the takeover premium prior to small deals, while changes in liquid call option prices do not explain any portion of the takeover premium for large deals. These results show that informed options trading is concentrated prior to small deals (which are unlikely to be investigated by the SEC) while informed traders abandon the options market prior to large deals (which are more likely to be investigated). Our paper contributes to a number of strands of research. First, we make a significant contribution to the literature examining the impact that regulations have on insider trading by showing that the threat of a SEC investigation materially impacts the market in which illegal insiders trade. Existing literature on this point is limited to studies evaluating the interplay between stricter regulations and the level of legal trading reported by corporate insiders (Arshadi and Eyssell, 1991, Seyhun, 1992, Agrawal and Jaffe, 1995 and Madison et al., 2004).7 While numerous studies show that illegal insider trading (trading by those insiders who do not report their transactions to the SEC) is prevalent prior to takeover announcements (Cornell and Siri, 1992, Meulbroek, 1992, Chakravarty and McConnell, 1997 and Chakravarty and McConnell, 1999), an evaluation of the deterrent effect of insider trading law enforcement on illegal insider trading in the options market is absent. Second, our paper contributes to the literature that examines informed trading in the options market. To our knowledge, ours is the first paper that addresses the impact of legal factors on the trading activity of insiders in the options market. Prior studies show that the options market is an attractive trading venue for informed investors (Cao et al., 2005, Pan and Poteshman, 2006 and Roll et al., 2010), and that informed trading is highly dependent on the leverage and liquidity offered by the options market (Lee and Yi, 2001, Chakravarty et al., 2004 and Anand and Chakravarty, 2007). Although Lee and Yi (2001) show that the options market is characterized by lower anonymity than the equity market, no study to date has examined how this market feature affects informed trading in light of anti-insider trading laws. The large sample employed in this study (816 takeover targets between January 1996 and December 2008) distinguishes our work from most prior research on the information signaled by option prices. Lee and Yi (2001) use a sample of 47 firms between 1989 and 1990, Chakravarty et al. (2004) utilize a sample of 60 firms between 1988 and 1992, and the sample in Anand and Chakravarty (2007) comprises 100 firms between July 1999 and October 1999. The larger dataset allows us to partition our sample based on different takeover and option characteristics and therefore explore further the underlying drivers of informed trading. Our use of a more recent dataset is also significant, considering that the legal and informational environment has changed significantly in the last two decades. For instance, in the 1997 case of US v. O’Hagan, 8 the US Supreme Court recognized the “misappropriation” principle. 9 As a result of this landmark case, a wider range of informed investors fall under the definition of illegal insiders. In addition, considerable progress has been made on the way information is disseminated between market participants. 10 The remainder of this paper is organized as follows. In Section 2 we give a brief overview of the relevant literature and develop our hypotheses. Section 3 explains the variables used in this study while Section 4 presents the main results. Finally, Section 5 concludes.

This paper investigates with the prevalence of informed trading in the options market prior to takeover announcements. Trading on private information prior to takeover announcements is risky, given that trading on most information that is not in the public domain is deemed to be illegal. This risk is exacerbated in the options market where the trading rules make it much easier to find the identity of traders compared with the equity market. This regulatory risk is offset by the large profits which can be earned is a small space of time. The central tenant of this study is whether informed investors trade in the options market prior to takeover announcements and whether the perceived risk of the SEC investigating for insider trading affects the level of informed options trading. Specifically, we hypothesize that in general informed options trading will be greatest for liquid call options and the call options which offer the greatest leverage. We also hypothesize that informed options trading will decrease as the perceived likelihood of the SEC investigating for insider trading increases. We find that the relative options-to-stock trading volume tends to increase prior to takeover announcements a benchmark period, which suggests that informed investors tend to gravitate to the options market prior to takeover announcements despite the greater likelihood of detection. Informed investors particularly disseminate their private information in liquid options and options offering the greatest leverage. We also find that changes in call option prices in the pre-announcement period explain a substantial portion of the takeover premium when the call options are liquid and offer large leverage. These results clearly show that informed options trading in the pre-announcement period is concentrated in liquid options and options which high implicit leverage. We run a logit model to identify the factors which increase the likelihood of a SEC investigation subsequent to a takeover announcement. Our logit regression results reveals that the single most robust factor which increases the chances that the SEC will investigate for insider trading deal value, with the likelihood being larger for large deals. By partitioning our sample according to deal size, we find that the increase in O/S in the pre-announcement period is most pronounced for small deals which are less likely to be investigated for insider trading. We also find that the cross-sectional pre-announcement O/S decreases with deal size. Finally, we find that changes in liquid call option prices in the pre-announcement period explain a large portion of the takeover premium prior to small deals, while changes in liquid call option prices do not explain any portion of the takeover premium for large deals. These results show that informed options trading is concentrated prior to small deals (which are unlikely to be investigated by the SEC) while informed traders abandon the options market prior to large deals (which are more likely to be investigated).