The Journal has an article this morning with the headline “BofA Times an Options Trade Well” that is about how BofA timed an options trade well. Specifically, in June 2012, it bought $60K worth of July $20 calls on Constellation Brands (STZ), and a week later STZ announced it was buying a big beer importer and its stock went up and BofA made about a million dollars on the calls.
But it’s not really about BofA’s smart timing; rather, it’s about the fact that BofA was an advisor and lender on the M&A deal, so it’s mighty suspicious that BofA’s options traders got this timing so right at the same exact time that its bankers and lenders were chock-full of confidential information.
Is it? My strong instinctive reaction is no, because I worked at a bank on the private side and also talked to equity vol traders, and it would never have occurred to me to call the vol traders and be all “hey we have a merger coming you should buy some calls,” and if it had, it would never have occurred to them to buy the calls instead of calling compliance and having me arrested. Because it is so dumb! For like a million bucks, too – likely far less than BofA made on its financing and advisory assignments. Like the man said, a million dollars isn’t cool. You know what’s cool? Not going to prison.1
Depending on your priors you can read this as a story about how data-mining on activity in thinly traded options just before merger announcements leads to a lot of false positives and uncalled-for eyebrow-raising, or as a story about how too-big-to-prosecute banks can get away with a lot of things that random dudes in Switzerland can’t. The Journal story is sort of silly, but it must be admitted that their evidence that BofA committed insider trading on STZ is not massively worse than the SEC’s and FBI’s evidence that some guy in Switzerland committed insider trading on Heinz. Insofar as nobody yet has any reason to think that the Swiss guy actually talked to anyone involved in the Heinz deal, whereas the BofA options traders and deal bankers shared a building, a bonus pool, etc. I think that that makes insider trading less, not more, likely, but I may be biased. But then the SEC might be biased too.
There are other lessons too. One is: regulators and journalists are utterly undone by derivatives positions with multiple legs. Remember how SAC switched its massive long position on Elan into a massive short position overnight when Mathew Martoma had nonpublic bad news about its drug trials? That turns out not to have been true: SAC was initially long on swap as well as physical, so its massive short position just offset its long swaps and brought it to around neutral. Regulators frequently have trouble with this. (Also: once there was a whale.)
Here, too, the Journal prints, but doesn’t really take seriously, BofA’s claim that this was a hedged trade and not as profitable overall as it looked on one leg:
Bank of America said it also placed trades around the same time betting against a rise in Constellation shares. Coupled with the bullish options trade, the bank said those bearish trades resulted in an overall trading position designed to capitalize on increased volatility in Constellation shares—not on their rise or their fall.
The bank acknowledged the trades were profitable but said “the net profit in this account from all the transactions was a small fraction” of the more than $1 million profit estimate. …
In addition to its call-options position, Bank of America said it bought put options on 133,100 Constellation shares as part of a strategy to be directionally neutral on the stock. However, the bank’s loss from the puts would have amounted to a tiny fraction of its profit from the calls.
Bank of America said it also sold Constellation shares short at the time, which put a bigger dent in its profit from the call options. The bank declined to say how many shares it sold short or when.
Well let’s figure out how many shares it sold short. Here I did the math for you:2
Notice the delta numbers there: to hedge the calls, you’d sell 37.9% of 150,000 shares or 56,850 shares; to hedge the puts you’d buy (62.17% x 49,700 + 14.85% x 83,400 = 30,898 + 12,385 =) 43,283 shares. So net you’d sell 13,567 shares to remain delta-neutral, or $263,607 worth at $19.43 per share.
You’d re-hedge periodically I guess but here things move pretty fast so let’s ignore that. The deal is announced a week later, on June 29, and the stock closed at $27.06 that day. It closed at $28.44 on the last day of trading before expiration, July 20. If you didn’t rehedge, your initial delta ended up worth $385,845 at expiry, so you lost $122K on your short position. And you spent $62K on your puts.
The Journal calculates that BofA made $1.21 million on the calls, which cost ~$60K and expired $8.44 per share ($1.266mm total) in the money. Even netting out the hedge BofA made about a million dollars. This ignores re-hedging, and it’s possible that BofA found a way to lose some extra money on increased volatility in what was after all a long vol position, but it’s still hard to get to a net profit of “a small fraction” of the Journal’s estimate.
This should be no surprise: BofA’s trade was buying a straddle,3 which is a long volatility trade4; volatility went way way up in the sense that the stock jumped like $8 in a week, so of course they made a ton of money. They didn’t bet on the stock going up – they spent as much on puts as they did on calls – they bet on volatility going up. And it did. A lot. Betting on volatility going up is a sensible way to bet on a merger being announced – especially one where, as here, Constellation was the acquirer so a positive market reaction was less of a certainty than was some sort of market reaction – so the excuse that it was a vol rather than directional bet doesn’t rule out insider trading. Keep those eyebrows raised, if that’s your thing.
Of course maybe BofA wasn’t just buying the position and formulaically delta-hedging it; perhaps there was some other client activity that they were hedging with these options.5 That would kind of make more sense, but of course they don’t say that: they just say “it was a vol bet and we hedged by shorting stock,” which suggests that my description and math are roughly right. Which brings me to another point: why is BofA making short-term, non-client-driven, prop bets on Constellation volatility?6 For better or worse or nothing or whatever, isn’t this the sort of thing that the Volcker Rule should be (slowly, slowly) shutting down? Scandals, I tell you. Scandals everywhere you look.
1. To be fair BofA lacks my confidence:
“We have no reason to believe there was any sharing of inside information” between the investment bankers who were involved in financing the deal and the traders who executed the options trade, said a spokesman for the bank.
What? Having “no reason to believe” we broke the law is pretty weak; I’d think at a minimum you’d want reason to believe you hadn’t broken the law.
2. So that math is from Bloomberg, STZ <equity> OV. Here is the Journal:
The Bank of America options trading occurred on June 22, 2012, according to market data. A Bank of America trader bought 1,500 call options, each allowing the bank to purchase 100 Constellation shares for $20 apiece through July 20. Minutes later, the bank bought 834 put options, followed by another batch of 497 puts. Those contracts allowed the bank to sell 100 Constellation shares for $17.50 apiece and $20 apiece, respectively, through July 20. Constellation shares were trading near $19.43 at that point.
Later they note that the puts cost BofA $62,210, versus this calculation (using Bloomberg mid-market data) of $61,683, so this is good within 1% error. Also the $0.4004, $0.9627, and $0.1659 per-share leg prices compare reasonably well with historical trading data (STZ US 07/21/12 C20 <equity> HP, STZ US 07/21/12 P20 <equity> HP, and STZ US 07/21/12 P17.5 <equity> HP) of $0.40, $0.95, and $0.15 on June 22, 2012.
4. And a delta-neutral-ish trade, so really why would you expect them to be short a ton of stock?
5. Or they did these trades as a market-maker in response to client demand? Client was like “man, STZ is boring, I’m gonna take a 1-month short vol position” and calls up BofA to make a market, which BofA does and then delta-hedges? That … would be terrible for the client, in this case. Also it looks (see note 2) a little like BofA paid above mids for these trades, suggesting it was taking rather than making liquidity, though that’s harder to tell from the data I have.
6. Obvs the fun answer is “to hedge their risk on the loan commitment they’d informally made to Constellation during the M&A process.” ESSAY QUESTION: Discuss the illegality of that answer.