When someone connected to a big merger gets information before it's public, and then buys a company's stock to make money on it, that's known as insider trading. It is part of the SEC's job to chase people who commit the crime, but it's not easy. Insider trading is rampant and the SEC has long been too poor to do the job right. As a result, it has often caught the smallest fish – the guys dumb enough to get caught – instead of the brilliant masterminds among big hedge funds and investors that could outsmart the law.
Over the past three years, prosecutors including New York's Preet Bharara have had more success tracking down alleged insider trading at hedge funds including Galleon by approaching it as they would a mafia case: elaborate, technology-savvy operations that include email scanning and wiretaps.
Still, you don't need a Homeland-like setup of surveillance screens, Bloomberg trading terminals and flowcharts to know if a merger shows suspicious evidence of insider trading. You can play along and spot the main forensic giveaways at home. You only need the internet and the free stock charts you can get through Google Finance, Yahoo Financeand MarketWatch's BigCharts.com.
Let's call it CSI: Heinz. The best part is that you don't need any math to be the star of this show. You just need the ability to spot unusually big numbers lurking among smaller ones.
The first number is usually the stock price. The first thing that gives away potential insider trading is a giant jump in the stock the day before a merger is announced. The number of shares bought and sold – which is known as the volume of the stock – is also important.
Heinz's stock price has been pretty pokey; it may well have been the most drama-free major stock in America before all of this excitement. For instance, here is a stock chart showing Heinz stock over the past five days. What it shows is that Heinz was completely flat at around $60 a share until the morning when Buffett's investing conglomerate, Berkshire Hathaway, agreed to join with investment firm 3G to pay $72.50 a share. There is an immediate sharp upward "cliff" in the stock on the morning of the announcement. That indicates that no one was moving the stock on inside information. Heinz doesn't show much evidence of insider trading by the criteria of stock price. (That doesn't mean there wasn't any, just that we have to keep looking harder.)
However, there's another stock-related number to check. All of the stock-trading sites have a category called Vol/Avg, which tells you the number of shares traded that day, as well as the average number of shares traded over time. Heinz's stock chart shows that on average, 3.56 million of its shares are traded on any given day. On Friday, however, more than 6 million shares traded hands; yesterday, when the deal was announced, more than 64 million shares of Heinz were zooming back and forth across stock exchanges. That shows that a lot of people were interested in buying and selling the stock, which is completely normal when a big deal is announced.
The key is to look at the volume on the day before the deal is announced. If no one knows a merger is coming, then the volume should be around the average.
If we're looking for obvious evidence of insider trading, we're out of luck on the stock volume too. MarketWatch's BigCharts.com has "historical quotes", which tell you how the stock traded on any given day in the past. On 13 February, before the merger announcement, there were 3.48 million shares of Heinz changing hands. That's below the average volume, which indicates sluggish interest in the stock.
No clear evidence of insider trading there. At this rate, CSI: Heinz looks close to being cancelled.
A boring stock? Not necessarily
It also doesn't help us that Heinz has been such a boring stock that speculators, like hedge funds, have not been very much interested in it before now. In this case, according to Yahoo and Google, the top 10 holders of Heinz stock are venerable firms like Vanguard, BlackRock and Federated Investors. These firms, which you may find in your 401k, tend to buy stocks and hold them. Heinz has been too dowdy to attract hedge-fund thrill-seekers, which explains why the stock price and the volume have been so flat for so long.
OK, so the stock price, the volume of shares and the owners don't give us much evidence that there was insider trading. It's all very Mayberry RFD, just another pokey week in a pokey stock. Do you give up? Change the channel? No. Hang in there. The juicy part is yet to come.
At this point, the professionals look at something a little more complicated: the options. Options are a way for sophisticated investors to speculate on the future of a stock. Options let them bet on what the price of Heinz – or Dell, or Exxon – will be in a given month.
An investor may believe, for instance, that Heinz stock will be near $55 in June. The $55 is known as the "strike price". The other number you need to know about options charts is "open interest". This indicates how many options contracts are bet at that price. It sounds complicated, but it's an easy number to understand: it's like counting the number of chips on a poker table. The more open interest, the more bets are being placed.
The key with options, like with stocks, is to look for numbers that look unusually high. In this case, the big numbers are going to be in the "Open Interest" column of the Heinz options charts, which are called options chains.
Now you have to use some forensic reasoning. Buffett's offer was $72.50, so if anyone was tipped off about the price of the deal, they'd want to buy a lot of Heinz options at a strike price of $70. ($60 would be too low and $75 would be too high.) But that didn't happen. You can click on the February, March and June options charts and find that the $70 price didn't have too much unusual activity – maybe a little more, but nothing crazy.
However, what stands out in the stream of numbers is this: all of a sudden, the day before the deal, the Heinz options snoozefest suddenly started to snort to life. A lot of people showed interest in buying Heinz at $65 a share in June.
An easy chart at ZeroHedge highlights what happened on 13 February, the day before the Heinz deal was announced: 2,593 options contracts were opened, betting that Heinz stock would be worth at least $65 in June. (The ZeroHedge chart shows a slightly higher number, but 2,593 is where it ended up). According to the estimates of one trader, that number of contracts would have affected about 250,000 shares of Heinz – a pretty significant number.
Maybe it was just a lucky guess? Maybe someone just had that much faith in the stock? It could have been. But there didn't seem to be much reason to believe that Heinz, that pokey, sleepy stock, would suddenly turn into a star.
Also, there's the timing of it. One Wall Street trader who was watching the options told me that the first bunch of options contracts moved at 2:22pm on 13 February, with another batch at 3:03pm. In trading hours, that was only three hours before the Heinz takeover was announced.
Now things are getting warm. To use the terminology of the CSI shows, there's enough there to start asking whether there may have been a premeditated move.
"Is it suspicious? Yes. Is it, 'Holy crap I've never seen anything like this before?' I'm not so sure," said a veteran Wall Street trader who bets on the prices of companies involved in mergers and acquisitions. But he saw no reason to assume that the options trading in Heinz was purely coincidental: "The SEC should be knocking on the door."