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The Usual Suspects

April 05, 2007

Dear Fellow Options Trader,

On multiple occasions in the movie "Casablanca," when confronted with crimes he does not really want to solve, Captain Renault (played by Claude Rains) orders his men to "round up the usual suspects."

This phrase is one of the most-quoted movie lines in the history of film. Renault, as the head of the Moroccan police force in Casablanca, issues the order to a group of policemen to help cover Humphrey Bogart's killing of the German major in the film's final moments.

"Rounding up the usual suspects" always comes to my mind when we're following unusual option-trading activity that registers on our HeatSeeker program because, even though the activity itself is extraordinary, it's always the same storyline that leads to those off-the-charts trading opportunities.

Sometimes I wonder whether Claude Rains runs the investigations on insider trading, as no matter what happens, they always come courtesy of the usual suspects on Wall Street. Here's the profile of the classic perpetrator: a clerk at the law firm, the person in charge of copier center, a junior trader or an assistant to one. It's never partners or officers at any of the big Wall Street firms who make these kinds of transgressions -- it's always someone who "should" know better but apparently doesn't.

There are two reasons why it is always the usual suspects who abuse "inside" information, and not those in higher positions

1. The partners are already rich and really don't want to bunk with Bubba.
2. The temptation is just too great for the underlings to take advantage of what they know and convert it into big-time cash.

Such was the case in TXU Corp. (TXU), a stock that HeatSeeker nailed for unusual activity prior to its takeover. Just last week, a judge in Chicago granted a restraining order to freeze a British couple's remaining assets in America, as the authorities feared they would transfer the ill-gotten gains outside the jurisdiction of the U.S. courts. Here is a quick quote from the U.K.'s The Guardian (Guardian.co.uk):

"The American authorities have accused a British couple of being central to an insider trading ring that made millions by buying lucrative options contracts just days ahead of takeovers, including the record-breaking $45 billion private-equity buyout of TXU, the Texas power company.

"Sunil Sehgal, director of a Wembley-based IT firm, Transputec Computers, and his wife Seema are the first people to be named in an investigation by the Securities and Exchange Commission, the Wall Street regulator, into unusual dealings in the run-up to TXU's takeover in February. The SEC says there were 'highly suspicious purchases of speculative call options' in TXU, partly made through the London branch of the investment bank UBS, yielding profits of $5.3 million for an unknown number of people involved. Call options are bets that a share price will rise in the short term. When TXU's imminent takeover was disclosed, its stock leapt by 13%. Mr. and Mrs. Sehgal are accused of making $270,000 from their part in the well-timed deal."

HERE WE GO AGAIN

Fast-forward a few weeks, long before the announcement of the recent $25.6 billion takeover of First Data (FDC) by Kohlberg Kravis Roberts, as our HeatSeeker picked up unusually heavy buying of calls in the credit card processor. And from where I sit, this situation stinks to high heaven of news leaking just prior to the deal being done.

In February, the average daily volume of FDC calls trading hands was 1,826 contracts, but our data shows that anywhere from 10 to 18 times that amount changed hands during the course of several days in March. Most notable was the activity that took place on Friday, March 23, which is typical in the face of an expected takeover. But when nothing happened during the weekend, buyers came right back in on Wednesday, Thursday and Friday of last week, which you can see in the graphic below:



The FDC April 27.50 Calls closed at 60 cents on Friday, March 30 and then they exploded to nearly $6.50 based on the announcement of the deal on Monday, April 2. The other options the "smart money" bought, the May calls at both the $27.50 and $30 strikes, which were trading at $1.10 and 40 cents respectively, also made the buyers a small fortune based on the $34-per-share cash takeout.

If I cull the average daily trade of roughly 2,000 contracts out of the volume on the days in question, and account for market-maker hedging, I come up with an estimate of $9.4 million made on what certainly looks to be insider trading. Here is our data detailing the activity:

DATE	CALLS TRADED
March 15	470
March 16	1,207
March 19	1,178
March 20	3,632
March 21	4,038
March 22	878
March 23	12,834
March 26	7,811
March 27	8,797
March 28	34,147
March 29	18,675
March 30	10,717

It just goes to show that the flies on the walls who seemingly go unnoticed are the ones who take what they learn and exploit it to their advantage. But while their initial profits may taste sweet, the victory is only an ephemeral one. It will only be a matter of time before they see their names in the news in conjunction with "insider trading" and "SEC investigation."

And yet, it's only a short matter of time before the next junior trader (who probably reads those headlines and thinks, "That won't happen to me") gets his or her hands on the same type of information. No doubt, we'll be reading the next batch of headlines and thinking, "Haven't I heard this one before?" I'll tell you, all reporters have to do is keep the same story handy, and switch out the names and stock tickers every couple of months. At the rate that insider trading takes place, heck, they probably already do!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader