INVESTIGATETHESEC.COM

Several Options for Fraud – April 10, 2008

David Patch

Has Wall Street’s Options Market become the haven for fast money amidst securities fraud?

It was not too long ago that we witnessed a significant explosion of questionable options trading activities leading into mergers and acquisitions with several resulting in SEC enforcement actions.  The SEC concerned enough about the insider trading activities that they have hosted a spotlight on insider trading section on their web site (http://www.sec.gov/spotlight/insidertrading.htm ).

As evidenced by the enforcement actions taken, the options market was the venue of choice in gaining the highest payback on investment.

Third party manipulation can also take place using the options market as short sellers overload the system with Put contracts forcing the Options Market Maker to sell down the equity through their exemption to naked short the stock.  Naked shorting is the practice whereby the short sale is placed without requirement of a locate or delivery unlike the normal market short sale. 

The options market maker has been provided regulatory exemption from the locate and borrow to allow the firm to balance their books in creating market liquidity.

As Bear Stearns collapsed late last month, a significant rise in options Put contracts exploded into the market.  The short sale negativity in the options market carried over to the equity market through use of the market making exemption.  Soon all buy-side demand in the equity market evaporated under the pressure of teh options market hedging taking place.  Settlement failures in the equity exploded as the market collapsed.

Many believe that the unusual rise in the options trading was a sign that investors knew an event was to take place before the actual fall and traded on the news.  The red flag in trading was the level in which these bets were being placed as a large quantity of contracts were purchased well out of the money requiring a very small purchase premium but also required a better than 50% market drop in a matter of days.

What we have now come to learn is that rumors were being disseminated throughout the market trading desks discussing the availability of capital at Bear Stearns.  The rumors, false at the time they initiated, created the event necessary for the options contracts to become significant in the money contracts.

We hear of these stories because they involve big players.  Bear Stearns was the 5^th largest US Bank at the time of this collapse.

Left unprotected are the smaller players.   The issuers and investors the SEC has rated insignificant with regards to fair market practices and rights.

On April 8 RealMoney.com contributor Rebecca Engmann Darst published a column titled “Option Traders Expect a Slump in Small-Caps”.   In her column she discussed small cap retailer Overstock.com.

“The mood of anticlimax extended to options of another small-cap stock, the online discount merchant Overstock.com (OSTK). Shares in the company rose 5% to $13.92 this afternoon on no apparent news catalyst, but a sixfold increase in option trading volume shows many traders taking the opportunity to stake bets on limp share-price movement heading into the hot season.”

Darst analyzed the trade data and opined that the trader had a “clear anticipation that the buck stops right about here for Overstock.com” as the volume in the $12.50 Puts skyrocketed.  At the time of the options trades the equity itself was trading near $14.00/share.

So how did this trader make out now that the trade is two-days old?

April 10^th became the day that Gradient Analytics, under lawsuit by Overstock.com for colluding with short sellers to draft hatchet job analysis, filed a counter claim to the lawsuit filed by Overstock some 2+ years ago claiming Overstock libeled them.

The announcement of the countersuit dropped the market in Overstock.com $1.31 (9.28%) to a closing price of $12.81 after hitting an intraday low of $12.31. 

Was this remarkable luck on behalf of this trader or was it more?

To think that a large short position, six times normal trade volume, is executed just days before this news is released is far too coincidental.  The trading raising additional spotlight on the relationship between Gradient and the short sale community as this investment made was a short interest position taken.

With the spotlight squarely on the SEC’s Division of Enforcement, Congress requesting yet another GAO investigation into the division’s policies and effectiveness, this incident will provide for a large contingent of public followers.  The SEC’s alliance with short sellers have come into question repeatedly as they muddle through short sale reforms and with the options market again being called into question the division will be expected to report out on how infiltrated the market is with fraud and corruption.

It will also be interesting to determine if, like Bear Stearns this six times rise in options trading bogged down the equity market with shares that would not and could not settle.

Did the potential crook use the market making exemption as the vehicle for the fraud where, had the SEC acted on the 2006 public proposal to eliminate such exemption those sales may never have been executed?

I contest that the delays in this policy change were certainly a primary contributor to the demise of Bear Stearns last month and most likely will show up as the contributor in this potential fraud as well.

Stay tuned on this one as one thing is for sure, there is no fear by the crooks here.  The Options Market leaves plenty of opportunity for fraud to happen rather easily and for the most part, without enforcement.