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How to Profit from Insiders: Part I

Monday, October 25, 2010 | Ed Pawelec

Sometimes in life there is no other way to learn other than by making a mistake.  If you are paying attention, sometimes you can learn from other peoples' mistakes without having to make them yourself ... and in time put them to work for BIG gains ...

Railroaded into an important lesson

The year was 1996, and I was just about 3 months into my first independent market making job.  I had been on the floor since 1993, starting as a clerk and having worked my way up to the point where someone was willing to give me some money to trade. 

I was trading in the Newmont Mining pit.  There were other stock options traded in that pit, but pits were usually named by their most liquid options.  Included among those other options were Placer Dome, McGraw Hill, Union Pacific, and Conrail, to name a few.  The only one among those names that I didn’t trade was Conrail, and I was pushing my boss to let me add that one to my book.  There was decent enough order flow, and as a market maker you want to trade as many products as you can manage. 

But as I mentioned, I was new, and my boss felt that 4 products were enough and that we could reevaluate after 6 months.

One of the reasons a smart boss will make you start out small is that, even though you might be strong in options theory, applying that in fast paced floor trading is an entirely different proposition. 

We didn’t have computers to tell us our position ... or how much stock we'd need to hedge an options trade; it was all done with paper and a pencil and some fast estimations.  A few times a day, you would ask your clerk for some hard numbers to reconcile your scribbling with your real position.  But I digress ...

The train, she was a coming

Monday, October 14, 1996 was shaping up as an uneventful day for most of the traders on the floor. 

For me, however, it was the first expiration where I had some real position management to do.  As I mentioned, I had only been trading “for real” for about 3 months, and it takes time to build a position.  Late that afternoon, as I was fastidiously ensuring that all my numbers were right, the first fateful trade in Conrail came in.

For those of you too young to remember, Conrail -- or Consolidated Rail Corp. -- was a railroad created in the 1970’s by the government out of  a number of northeastern rail companies that were tumbling one by one into bankruptcy.  In 1987, the government took the company public in what was, at the time, the largest IPO in history at $1.65 billion or $28 per share.

Nearly 10 years later, the stock was trading around $71 1/8.  Yes, this was back in the day when stocks and options traded in eighths and quarters. 

Conrail was a slow and steady stock, with implied volatility in the low 20% range, which meant that on October 14, 1996 -- with only 5 days until October expiration -- the upside calls were basically worthless.  At 20% implied volatility, the expected range over a week of trading for a $71 stock would be approximately plus or minus $1.50.  So the Oct 75 calls (the right to buy the stock at $75 in 5 days) were no bid at 1/4 and the Oct 80 calls were no bid at 1/8.

The first order was to buy a few hundred Oct 75 calls for a quarter.  The market makers jumped all over this -- after all, it was essentially free money; there was no way the stock could jump nearly $4 in the days ahead.  Then it happened again, a quarter for another few hundred.

At this point, I was getting ticked off. 

These guys were getting free money, and since I didn’t trade the stock, I was getting bupkiss.  I went to my boss and excitedly told him what was going on.  Since we were considering adding Conrail to my book, I thought now might be a good time to jump in and capture some of this free cash. 

Remember, I was still pretty new.  He looked at me like I had just suggested a field trip to Area 51 so we could say Hi to the aliens.  “You don’t see anything wrong with that?” he asked.  The only thing I could see wrong was that I wasn’t making any money from these idiots willing to pay two bits for worthless options.  He told me to go back and watch.  Grudgingly, I did so.

By the time I got back, not only had someone paid an eighth for the 80 calls, they were now paying a quarter for them, and the 85’s were now an eighth bid.  I just fumed.

The real problem with these calls is that the model has them as worthless -- so there is no valid hedge.  Normally, a market maker would buy stock against calls that he sold based on the delta of those calls.  There were no deltas in these calls, so unless you just decided to lean long and buy some amount of stock, you could just sell them and it wouldn’t affect your net position.

The rest of the market makers in the crowd finished the day content in their knowledge that they would be making a few hundred extra eighths and quarters when October options expired in a few days.

Oh the humanity!

It came as a surprise to nearly everyone (except the person or persons who bought those calls) when, the next day, CSX made a cash and stock offer for Conrail that amounted to $92.50.  The stock opened on October 15, after much delay, at $88.

The 75 calls that were sold for $.25 were now worth $13!  The 80 calls that were sold for $.125 were now worth $8, and so on! 

I was not looking forward to going to the floor that morning, because although I had not been involved, I had plenty of friends who were out tens of thousands of dollars, and they would have to stand there and wait -- in pain -- to find out just how much damage was done when the stock actually opened for trading.  Some of them would lose their jobs.

I rode the elevator down with one of the market makers involved in this debacle, and he was looking a sickly sort of gray.  There was a moment of concern that he might puke all over me, but really I just had sympathy.  These were honest, hard-working guys.

Looking good Billy Ray!

Obviously, someone had made some outrageous money on some inside information, reaping returns of 2400% to 5200% over night.  The market makers were not among them.

I was fortunate not to be involved, but the lesson was not lost on me:  When options start trading in size -- and repeatedly -- something is going on.  In the heat of the moment I was more than willing to throw myself in front of this train for pennies; thanks to my boss, I didn’t. 

This indelible impression that was made on me by someone else’s mistake stayed with me.

So much so that I studied each of the quadruple digit gains that came across the floor carefully for the rest of my career.  It's now one of the reasons I closely monitor option order flows.  Option markets are a great place to hide when big players have important information that you don’t.  Usually their actions are driven by research on a level that individual investors can’t compete with.  Hedge funds and institutional investors talk to company managers and industry experts on a regular basis, and they frequently go to the options market to enact their opinions. 

It's also, as in this case, insider trading ... there are hundreds of thousands of people who know about thousands of earnings announcements, drug approvals, government contracts, and takeovers that happen each year.  With these kind of quadruple-digit gains, some of them are willing to test the idiom "crime doesn't pay".

While I don’t jump all over every big trade I see, they do put the target stocks on my radar.  From there I review my checklist, check my software, and make a better decision on whether to follow the flows or get out of the way. 

Getting a handle on option flows can give you an edge to BIG gains other investors do not have. I'll be sharing more with you about this soon ...

In a pseudo happy ending, many of the market makers who got crushed that day recovered a portion of their losses in the early 2000's when some of the insiders (they were not actually company insiders, but they were trading off of material non-public information) settled a class action suit.  Still, they had to carry those losses for more than 5 years before they got anything back.

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Ed Pawelec
Contributing Editor
Price Shock Trader
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