A Ship of Fools?

First, I’ll preemptively apologize for the nautical allusion – yes, Galleon is a hedge fund named after a boat as basically every media outlet has realized, and yes, it is now sinking (couldn’t resist that last double entendre, sorry).

After reading the SEC complaint in full, I wanted to call attention to an earlier post about my surprise regarding the paltry size of the alleged insider trading. Noting that $20 million was an infinitesimal fraction of Galleon’s assets under management and Rajaratnam’s wealth, I gave three possible explanations for the activities. At the time, having not read the complaint, I forgot to mention a fourth possible cause – perhaps the companies in question were too small to permit large scale insider trading. As several insiders have found out, attempting to commit large scale fraud with small stocks is very stupid. The SEC isn’t run by rocket scientists, but they will catch you.

To be more specific, when people have insider information, they often try to maximize gains by trading options. As I noted in an earlier post, options provide leverage, magnifying wins and losses. If you know what’s going to happen to a stock on account of insider information, trading options therefore seems like a great bet – you’ll get the best bang for your buck. Indeed, it can be quite lucrative. However, in many cases, it can be a big red flag to the SEC. Many stocks don’t support very liquid options markets. This is to say, the open interest (number of existing options contracts on a stock) and volume are often very small, so it takes only a few extra trades to cause a big spike in activity. And the SEC will catch such volume spikes as Reza Saleh recently found out the hard way when he bought 9,332 Perot Systems call options on insider knowledge of a buyout.

So, returning to the Galleon case, I’m not that surprised that some of the reported gains were quite small. For example, options on Polycom (one of the companies in question) have very low open interest and rarely trade. The complaint alleges that one of the parties purchased 200 Polycom calls from April 13 to April 18, 2006 at $1.35 a piece. Now, this was a very small outlay (resulting in a profit of only $22,000), but anything larger could have tipped off regulators then and there since on average only about 200 calls trade per day in the stock.

But the same can’t be said for some of the other companies in the complaint. Google, for example, supports a much more liquid market. One of the parties purchased 566 put options in the two weeks leading up to Google’s 2007 second quarter earnings announcement. While this trade led to more than $500,000 in profits, the party probably could’ve put on much more of it without alerting regulators. By my estimates, roughly 7500 puts on Google exchange hands every day. Now I don’t know how the SEC’s volume spike algorithm works, but I see no reason why the party couldn’t have bought 500 puts (across strikes) per day without tipping off regulators. If the party had amassed 2500 puts in total, it would still probably account for less than a quarter of the open interest across strikes and would’ve made several million dollars more in the process.

Was this person just overly concerned about getting caught or simply a fool?