This article originally appeared on The Options Insider Web site.
I can still vividly recall my first days as a young trader on the Chicago Board Options Exchange (CBOE). Those memories are filled with the fear, frustration and fleeting moments of success that mark the beginning of any trading career.
Some memories from those days are more vivid than others, especially those that revolve around insider trading I remember the first time that I saw the old-timers around me flee the closing bell. They simply folded up their sheets, turned around and left the trading floor 15 minutes before the markets closed. Needless to say, it was a strange sight.
Their sudden departure surprised me. After all, the volatility surrounding the last few minutes of the day can often lead to interesting trading opportunities. However, after watching these experienced traders pack up and leave before the close every day, my curiosity finally got the better of me.
I pulled aside one of these old-timers and asked him why he always left the floor 15 minutes early. He just looked at me, shook his head and said, “Kid, you don’t want to be down here at the close. That’s when all the pick-off paper comes in.”
It was a surprising revelation, and one that I soon took to heart.
Beware of Brokers Bearing Large Orders
What is pick-off paper? This is the order flow that, as a market maker, you do not want to touch. Pick-off trades are the trades where the customer knows something that you don’t, and that usually amounts to inside information.
Skeptical? So was I, at least at first. After all, insider trading is illegal and (supposedly) closely monitored. So there is no way that it could occur with such regularity. Someone would certainly catch on after a while … right?
Unfortunately, as the months and years rolled on, I learned that was not the case. Time and again, I watched orders roll in that pushed the boundaries of credulity.
On a slow day, when your entire product trades only 10,000 or 15,000 contracts, it is hard not to raise an eyebrow when a broker runs into your pit with an order to buy 10,000 upside calls five minutes before the bell rings. It is even more difficult to hold your tongue when an analyst for the same firm upgrades the stock after the close or just before the open the next day.
This scenario, or some version of it, played out with such alarming regularity that it became a running joke in the options business. If you saw a broker for any large bank/brokerage house sprinting toward your pit just before the close, then you knew that it was time to leave. This activity was not endemic to any particular product or even to a particular exchange, it was just the nature of the beast.
The Dark Family Secret
Like anyone, I grew outraged whenever I first saw this questionable activity. Filled with righteous anger, I stormed over to the officials responsible for investigating such activity and demanded action. What I received was a knowing nod and a calming pat on the shoulder.
I quickly learned was that I was hardly the first person to raise such questions, and I wouldn’t be the last. Many good people had gone down that road before me, only to be frustrated by the high standard of proof and the multiple accounts that most insider trades are routed through.
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At the end of the day, it’s nearly impossible to prove that account X possessed material, non-public information, and acted on it, particularly when their orders are routed through multiple accounts and brokerage firms.
So this activity eventually became the dark family secret of the options business. Everyone knew that it was there, but no one really talked about it, especially with outsiders. Smart traders learned to spot the pick-off paper and get out of the way, a necessary defense mechanism for any long-term career.
No One’s Watching
Why is insider trading so popular in options? There are several reasons.
The first is leverage. If you have information that a stock is going to move rapidly in a short period of time, then options will give you the most bang for your buck. You can accomplish the same thing in the underlying stock, but it will require much more capital and a much larger position, two things that may draw unwanted attention.
The second reason is, quite simply, the lack of oversight. The SEC is first and foremost an equities regulator. They have little time, patience or manpower to track insider trading in the options market. This leaves much of the oversight burden to the exchanges, which are already busy tackling numerous other issues.
The oversight role of the exchanges is also complicated by the competitive situation in the industry. Every exchange’s survival is dependent on their relationships with the large order flow providers. As a result, many of them are reluctant to launch potentially embarrassing investigations, and risk jeopardizing those relationships, just to track down a few shady customers.
All hope is not lost, though. There have been a few interesting developments on the insider trading front in recent years.
The CBOE spearheaded the creation of the Options Regulatory Surveillance Authority (ORSA), which was finally approved by the SEC in 2006. ORSA combines the insider trading surveillance activities of all six exchanges into one body, allowing them to pool their resources and share information about potential violators. It’s a promising concept that was long overdue.
Hope for the Future?
At the end of the day, the best oversight may lie with the investing public. Insider trading has hidden in the shadows of the options market for decades.
However, with options exploding in popularity every year, and more eyes turning toward this marketplace every day, it is becoming much more difficult to hide.
There are options monitoring services and a wealth of other tools available to today’s customer that were unimaginable just a few years ago. All of these new tools and new traders make it much more difficult for questionable activity, such as the Dow Jones trades, to escape unnoticed.
Of course, now that the financial media has been awakened to the dark secret of the options world, we can hope that the level of scrutiny will only increase in the coming weeks and months.
Insider trading is no longer the dirty little secret of the options markets. The cat is finally out of the bag, and violators had better take note.
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