When is informed trading more prevalent?—An examination of options trading around Indian M&A announcements

• Date: 01 June 2020
• Author: Archana Patro,Soniya Mohil,Reena Nayyar
• Published date: 01 June 2020
• DOI: http://doi.org/10.1002/fut.22102

J Futures Markets. 2020;40:1011–1027. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

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Received: 6 July 2018

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Accepted: 15 January 2020

DOI: 10.1002/fut.22102

RESEARCH ARTICLE

When is informed trading more prevalent?—An

examination of options trading around Indian M&A

announcements

Soniya Mohil

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Reena Nayyar

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Archana Patro

1

1

Finance and Accounting Area, Indian

Institute of Management Rohtak, Rohtak,

India

2

Finance and Accounting Area,

International Management Institute New

Delhi, New Delhi, India

Correspondence

Soniya Mohil Research Scholar, Finance

and Accounting Area, Indian Institute of

Management Rohtak, Management City

NH‐10 Southern Bypass, Sunaria, Rohtak,

Haryana 124010, India.

Email: fpm02.008@iimrohtak.ac.in

Abstract

This study examines the prevalence of informed trading around proximate‐date

versus far‐date mergers and acquisitions (M&As). Further, different options

strategies pursued by informed traders in proximate‐date M&As are identified.

The results highlight that proximate‐date M&As are associated with a

significantly higher level of informed trading vis‐à‐vis far‐date M&As. Results

on the choice of options strategies highlight that risk‐averse, informed traders

may pursue a straddle strategy to profit from their private information, while

risk‐seeking, informed traders may use a vertical call spread strategy. Informed

traders desirous of hedging their existing positions may employ a protective put

strategy.

KEYWORDS

far‐date M&As, informed trading, mergers and acquisitions, options strategies, proximate‐date

M&As

JEL CLASSIFICATION

D82; G14; G3; G34

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INTRODUCTION

Announcements of mergers and acquisitions (M&As) are important company‐specific events, around which an

immense amount of information is processed. The possibility of any upcoming M&A announcement may trigger

trading in shares of the acquiring companies well in advance. This preannouncement abnormal trading in the acquiring

companies' shares may either be influenced by anticipators or informed traders,

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leading to abnormal gains/losses.

Generally, anticipators trade in an acquiring company's shares based on publicly available information. Meanwhile,

informed traders trade based on privately available, superior information pertaining to the acquiring company. In

markets with asymmetric information, when informed traders try to derive abnormal gains by influencing the price of

an acquiring company's stock using private information relating to the acquiring company, this is considered illegal.

However, it is difficult to identify whether the preannouncement trading is based on publicly available information and

is legal or is based on superior private information and is illegal (Ordu & Schweizer, 2015).

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Informed trading comprises of insider informed trading and noninsider informed trading. Insider informed trading is also known as illegal insider trading. Some of the researchers use insider trading

as an alternative term for informed trading as it constitutes the major portion of informed trading. Our objective is not to distinguish between these two terms but to examine if material nonpublic

information is used ahead of M&A announcements. For this, we use a wider term, informed trading, to consider trading done based on material nonpublic information. We thank the reviewer for

highlighting this important point.

To realize abnormal gains, informed traders, who possess private information pertaining to the acquiring company,

prefer to exploit the information by trading in the options market rather than in the stock market. This is true

specifically in cases where the underlying acquiring companies have an option listing status (Arnold, Erwin, Nail, &

Bos, 2000). The reasons are first, trading in the options market is cheaper than in the stock market and hence, offers

opportunities for higher profits for the insiders (Amin & Lee, 1997; Black, 1975; Cox & Rubinstein, 1985; Dubrian,

Fung, & Lovelandrobert, 2018; Easley, O'hara, & Srinivas, 1998; Geppert & Kamerschen, 2008; Jayaraman, Mandelker,

& Shastri, 1991; Manaster & Rendleman, 1982; Ross, 1976; Skinner, 1990; Stephan & Whaley, 1990). Second, the options

market provides more choices of trading strategies to insiders and helps insiders hedge the risk or earn abnormal gains

(Atilgan, 2014; Bettis, Bizjak, & Kalpathy, 2015; Bhuyan & Chaudhury, 2005; Biais & Hillion, 1994; Chiang, Chung, &

Louis, 2017; Diamond & Verrecchia, 1987; Grossman, 1986; Jayaraman, Frye, & Sabherwal, 2001; Ordu & Schweizer,

2015). Third, the options market provides informed traders an opportunity to hide their illegal activity, as a plethora of

option contracts is available with different strike prices and different maturities on a given underlying stock (Easley

et al., 1998; Arnold et al., 2000; Clements, Singh, & Van Eekelen, 2007; Wang, 2008).

Billings and Jennings (2011) propose that the value of “at the money”(ATM), short‐dated options may increase

when the expiration of these options align with the timing of the earnings announcement. Similarly, Ding (2009), who

analyzes the options strategies developed by informed traders before earnings announcements, suggests that the

profitability of options strategies deviate significantly in cases where the option expiry date and the earnings

announcement date coincide with each other. Since informed traders prefer trading in the options market and the

options market may offer opportunities for larger gains in cases where the announcement date of a company‐specific

event aligns with the option expiry date, there may be a high possibility of informed trading during the announcement

of such company‐specific events. However, to date, the prevalence of informed trading under the context of date

alignment has been explored by researchers only for earnings announcements. Hence to fill this gap in the literature,

this study examines the prevalence of informed trading around M&A announcements, where the M&A announcement

date and option expiry date are proximate to each other.

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We define these M&As as proximate‐date M&As. Proximity

here means that the M&A announcement date and options expiry date either exactly match with each other or the

M&A announcement happens in the option's expiry week (Billings & Jennings, 2011; Ding, 2009). Meanwhile, M&As

where the M&A announcement date either does not exactly match the option expiry date or M&As that are not

announced in the option's expiry week are defined as far‐date M&As. Further details on proximate‐date M&As and

far‐date M&As are given in the section on data and sample selection. Thus, the first objective of the study is to identify

the prevalence of informed trading around proximate‐date M&As and far‐date M&As for the Indian acquiring

companies with listed options.

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The reason for considering Indian M&As is that in India, despite amendments in insider‐trading regulations by the

market regulator, Securities and Exchange Board of India (SEBI), it has been very challenging to prove the prevalence

of illegal insider trading (Dutta & Venkatakrishnan, 2002). Hence, the enforcement of insider‐trading regulations in

India has not been as rigorous as in the case of developed markets like the United States (Manchikatla & Acharya,

2017). For instance, in the case of SEBI versus Hindustan Lever Limited (HLL, now Hindustan Unilever Limited),

1997, SEBI accused HLL of insider trading before the merger of HLL and Brooke Bond Lipton India Limited (BBLIL).

SEBI claimed that HLL, being an insider, purchased 0.8 million shares of BBLIL a few weeks before the public

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Let us look at two different cases to understand how informed traders reap the benefit of the M&A effect in the case of proximate‐date M&As. In the first case let us assume that the informed trader,

Mr. M, has information that its company, X Limited, will be publicly announcing an acquisition on January 25, XXXX. Further, assume that the spot price of X Limited's shares is 85, and Mr. M

understands that due to the strategic advantage ofthe acquisition there will be a huge upsurge in the price of the company's stock. To reap these abnormal gains, he buys one call option at a strike price

of 100 with expiry date of January 25, XXXX. The informed trader will exercise the option only when the spot price is more than 100 on the exercise date. Let usfurther assume that the stock price on

the announcement date (January 25, XXXX), which in this case is exactly the same as the exercise date, has surged to 111. The informed trader will exercise the options, will buy the stock at a price of

100 and will simultaneously sell it at 111 to make a neat profit equal to the difference between the purchase and sale prices after adjusting for options premium or commission, if any.In the second case

let us assume that the informed trader, Mr. N, has information that its company, Y Limited, will be publicly announcing an acquisition on January 23, XXXX. Further assume that the spot price of Y

Limited's shares is 85, and Mr. N understands that the acquisition will be value‐destroying and lead to a huge downfall in the price of Y Limited's stock. To hedge his risk against the downward trend in

the price, he buys one put option at a strike price of 80 with expiry date of January 25, XXXX, which is not exactly the same as the announcementdate but is quite close to it and reflects the effect of the

acquisition announcement on the share price of the acquiring company in the spot market. The informed trader will exercise the option only when the price is less than 80, on the exercise date. Let us

further assume that the stock price on the expiry date, that is, on January 25, XXXX, has gone down to 75. The informed trader will exercise the option, sell the stock at a price of 80 when the market

price is 75 and make a neat profit equal to the difference between the exercise price and market price of the share after adjusting for the options premium or commission, if any.The difference in

the above two cases is that in the first case the informed trader could reap the benefit of the M&A effect when the exercise date and announcement date are exactly the same. Meanwhile, in the

second case, the informed trader could hedge his risk and earn an abnormal gain when the expiry date is close enough to (not necessarily the same as) the announcement date. However, if the M&A

announcement happens to be too many days before or after the option expiry date, the effect of the announcement on the spot price on the day of the option's expiry does not happen or is foregone.

This implies that despite the expiry date being constant, the informed trader, who possesses privateinformation about the exact announcement date, can reap the M&A gains or can hedge the risk of

value‐destroying M&As, even in cases where the options expiry date is proximate to the M&A announcement date.

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The study focuses on only acquiring companies due to nonavailability of the transaction wise options data for target companies.

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