September 19, 2001
The World's Largest Insider Trading Scam?
In the wake of the terrorist attacks which caused the destruction of the Twin Towers of New York's World Trade Center, damaged the Pentagon, and destroyed four large airliners with all aboard, securities-exchange investigators on three continents are poring over trading records to determine whether one or more parties profited by their advance knowledge of the disaster.
Investigations are focusing on the many different ways and places in
which profits could be made following the Black Tuesday outrage.
A brief introduction to "left-handed trading" will help to clarify what
may have happened.
Short SellingMost investors buy stocks much the way they buy houses: They try to buy cheap and sell dear. Some traders, however, try to accomplish the same thing in reverse order -- when they think a stock will decrease in value, they sell the stock first, in the belief that they will be able to buy it back at a lower price later. This is known as short-selling. In order to sell a stock short, a trader must work with a stockbroker who will lend him/her the stock to sell; this is a normal service provided by stockbrokers. At least in theory, an investor can wait a long time before buying back the stock that s/he has sold ("covering the short").
Short-selling can be a highly successful trading strategy for an investor
who knows how to time the market and can recognize overpriced stocks before
the general public does. On the other hand, it can be highly risky:
Since there is no upper limit to how high the stock being shorted can rise
in price, the potential loss to the short-seller is infinite. On
the other hand, the investor who shorts a stock with advance knowledge
of news that will cause its price to drop precipitously can make a killing.
Derivatives - Options and Futures"Derivatives" are investments that do not involve buying and selling something that has direct value -- such as shares of stock or boxcars of wheat -- but instead involve buying or selling standardized contracts that give their owner the right (or obligation) to buy or sell a stock or a commodity at a particular time and price. For example, a commodity futures trader may spend all his working life buying and selling contracts to purchase boxcar-loads of pork bellies, but unless he badly botches his trades, he will never actually have to take delivery and see or touch a pork belly.
Derivatives relating to stock markets include stock options and stock-index futures contracts. Stock options are contracts that give their owner the right (but not the obligation) to buy ("call" options) or sell ("put" options) stocks at a set price (the "strike" price). American stock options can be exercised at any time until their expiration date; European stock options can be exercised only on one particular day. To prevent total anarchy in the options markets, options are written with standardized expiration dates and standard prices -- for U.S. markets, the last exercize date is the third Friday of each month, and the prices are in intervals such as $40.00 (per share), $42.50, $45.00, and so on. Each option contract gives the right to buy or sell 100 shares of the underlying stock.
Stock options are traded on several different exchanges, including the Chicago Board Options Exchange, the American Stock Exchange, and a number of others.
A stock option can be either "in the money", "at the money", or "out of the money". An "in the money" option is one that has an immediate value -- such as a call option that allows its owner to buy a stock at $50.00 per share when the stock is currently worth $60.00 per share. (In this example, one option contract would be worth $10.00 per share for 100 shares, for a total value of $1,000.00.) Similarly, a put option is "in the money" when the stock is currently worth less than the option's strike price. "At the money" options are options whose strike price equals the current price of the underlying stock; "out of the money" options are options that have no "real" value because they give their owner the right either to buy the stock at more than its current market price, or sell it at less than the market price -- in other words, they will have no value at all unless the stock price changes (in the right direction) before the options expire.
This brings us to one last point about options: Even "out of the money" options have some value, since there is a chance that they may become valuable at some point before they expire. This value is greater or less depending on three factors: First, the longer the option has to run, the more chance there is for the underlying stock's price to change so that the option will become worth exercizing; so longer-term options are more expensive than options that will expire very soon. Second, options that are only slightly "out of the money" are more likely to become worth exercizing than options whose strike price is far above (for calls) or below (for puts) the current market price of the stock. Third, options on stocks whose prices are normally volatile (such as technology stocks) have more chance of becoming valuable than "out of the money" options on stocks whose price doesn't generally change rapidly (such as utility companies). The value of an option contract (beyond any "in the money" value it may have) is known as the option's premium. As the option's expiration date approaches, its premium declines -- until, on the last day before it expires, the option's only value is the extent to which it is "in the money." Most stock options that are purchased never actually become "in the money," and so expire without being exercized.
Stock-index futures contracts are different from stock options in two important ways: First, they are based on the combined price of a basket of stocks, such as the Dow Jones Industrials or the Standard & Poors 500; so their value reflects broader economic and market trends rather than the specific success or failure of a single company. Second, index futures are more like commodity futures than like stock options, in that they represent an obligation to buy rather than the right conveyed by a stock option. An investor who believes that the stock market as a whole -- or one particular segment of it for which there is an index-futures contract available -- is about to decline, can attempt to profit by short-selling in the index-futures market.
Those who have found all the material above too simple will be comforted
by the fact that nowadays there are also index options - that is,
option contracts that give the purchaser the right to buy or sell a basket
of stocks rather than single stocks.
Black Tuesday and the MarketsAn event as dramatic and large in scale as the Black Tuesday attacks has a severe and far-reaching effect on worldwide stock markets. This effect is somewhat like the impact of a stone thrown into a pond: There are certain specific companies which are strongly and immediately affected by the attacks; others which are affected more weakly and indirectly; some which decrease in value only because of a general feeling of pessimism rather than because of any direct impact on their bottom line; and some which may even increase in value because they are seen as a "safe haven" in uncertain times, or because they may gain business from an upcoming armed conflict.
Another way of looking at this "ripple" effect is that the farther away a company is from the center of the impact (conceptually speaking), the greater the odds that it would emerge unscathed had the attacks' impact been less horrendous than it was.
The obvious members of the "first circle" of companies strongly affected by the attacks are American Airlines and United Airlines, the two companies whose planes were hijacked and used as flying bombs in the attacks on New York and Washington. These companies' stocks would have decreased in value as a result of any hijacking incident involving their planes, even one with a peaceful resolution. The same is true -- to a lesser extent -- of other airline companies, Boeing (the principal private manufacturer of airliners), and other companies that provide equipment and services to the air-transportation industry.
The next circle includes companies that would weather a "normal" hijacking incident relatively unscathed, but would be significantly affected by a more violent attack. These include the insurance and reinsurance companies which must cover the damage, as well as firms with a major presence in or near the Twin Towers.
The general stock market -- the "third circle" in our analogy -- would
not be strongly affected by a "peaceful" hijacking, but would be by a more
violent one. It could be argued that even the Black Tuesday attacks
as they occurred were not sufficient to cause a really bad "market break"
-- while the decline of the Dow Jones Industrial Average on the first day
of trading after the disaster was the largest on record in absolute terms,
it was not one of the top ten historical declines in relative terms.
Had the attacks been more completely successful -- for example, had the
fourth plane proceeded to Washington and crashed into the White House or
the Capitol -- the overall market would surely have suffered a much worse
crash. To understand what might have happened, it is worth comparing
the market's performance immediately post-Black Tuesday, when the Dow Jones
Industrials dropped by about seven percentage points, and the 1987 market
crash, when the Dow dropped by over 22 percent in one day even though there
was no obvious external reason for it to so.
Looking for Suspicious TradesCertain types of transaction can alert securities regulators that the investor who initiated them must have been acting based upon inside knowledge -- in other words, knowing some significant piece of news before the general public. A transaction will be considered suspicious based upon a combination of criteria:
Drawing ConclusionsAssuming that investigators are convinced that trades were made based upon advance knowledge of the attacks, they will obviously try to trace these trades back to determine who initiated them. Obviously, anyone who had detailed knowledge of the attacks before they happened was, at the very least, an accessory to their planning; and the overwhelming probability is that the trades could have been made only by the same people who masterminded the attacks themselves.
The difficulty, of course, will be in tracing the transactions to their real source. The trading is sure to have been done under false names, behind shell corporations, and in general to have been thoroughly obfuscated. If in fact the Black Tuesday attacks -- and the associated securities transactions -- were made under orders from Osama bin Laden, then we are dealing with an expert in masking ownership of corporations and making covert deals. This doesn't mean that unraveling the threads of these transactions will be impossible, but it probably won't be quick or easy.