ETF Stripping and Insider Trading

Eddie Braverman's picture
Rank: The Pro | 21,198

This post comes as a suggestion from HappyPantsMcGee (or HPM, or whatever the Diddy wannabe is calling himself this week). He asked me to explain the practice of ft.com/blog/2011/02/10/484126/sec-probes-etf-stripping-by-insider-traders-ft/">ETF stripping, especially as it relates to the recent insider trading charges filed against several of our dimwitted brethren. ETF stripping is a pretty clever tactic, and one of the ancillary benefits of doing it is that you can hide whichever stock you're really trading by trading all the others instead. Here's how it works:

Let's say you've got some inside information on XYZ. Let's just say they're about to announce a blockbuster drug approval that no one expected for at least another year. Now, you could go buy a bunch of XYZ a couple days before the announcement and just hope the SEC doesn't catch you. A better way to do it, however, might be to buy an ETF that holds XYZ as one of the component stocks. Then you short every other component of the ETF, the net effect being that you're long XYZ.

This is known as ETF stripping, because you've stripped the company you actually want to own out of the ETF (by shorting all the others), without actually buying the company's stock and leaving a paper trail for the SEC to find. Clever, huh?

Here's why this isn't a great strategy. Frankly, a lot can go wrong. First and foremost, it's a ton of effort to go to for something that might not actually pay off. You might have the best information in the world, but if the market ignores it you haven't made a dime on it. I know that's an unlikely scenario, but with the amount of time and capital it would take to short what could potentially be dozens of other stocks just to isolate the one stock you want to be long, this strategy is pretty steep on the risk/reward ratio.

Also, you run the risk of a rising tide lifting all ships. In other words, what if the news is so good (or so bad, if you've gone the other way) that it causes every component of the ETF to run up? The one company you're long isn't going to make up for the 25 you're short.

Bottom line: it's a cute strategy, but one probably best left to the theoreticians. If the guys trying to make a shaky buck with all these esoteric strategies would just devote that mental energy to adding value, they'd probably make more money and wouldn't have to worry about federal-pound-me-in-the-ass prison.

Mod note: "Blast from the Past - Best of Eddie" - This one is originally from 2/15/11

Comments (28)

Feb 15, 2011

worth the read guys

Feb 15, 2011
Edmundo Braverman:

Also, you run the risk of a rising tide lifting all ships. In other words, what if the news is so good (or so bad, if you've gone the other way) that it causes every component of the ETF to run up? The one company you're long isn't going to make up for the 25 you're short.

Correct me if I am wrong, but I do not believe you have any short exposures if you do your ratios correctly. You are short 25 stocks, but long the same 25 stocks + the 1 stock you want to take advantage of via the ETF, which makes you net zero exposure in the remaining 25 stocks and net long in the 1 stock. So why would you worry about the other 25 stocks at all?

Feb 15, 2011

You're correct, and that's a good point. But it's still a lot of work to achieve a dubious gain. Plus you have all the transaction costs and margin interest.

Feb 15, 2011

Eddie,

This strikes me as an overnight strategy more than anything else. It's easier to incur 1-2 days of overnight holding in this for a quick pop on the ETF around earnings before closing out the trade. Plus, as you said, unless you have massive capital to deploy, it's hard to do.

As an aside, nice use of Office Space, but I would have gone with this... I couldn't find a shorter video, so watch from 0:44 to 0:47. That kind of describes it... and if you know anything about Rahway State Penitentiary, it's supposedly far worse than most other prisons. Plus, it's got Weezer, how can you go wrong.

Feb 15, 2011

A friend of mine who trades credit told me about a guy who tried to play insider info on earnings for a F500 company with CDS because he didn't think they'd be able to trace it. Not only did the trade not really pan out (earnings disappointed but nothing catastrophic, so the gain was minimal) but he got pinched.

Feb 15, 2011

I think you meant to call Diddy a wannabe HPM, son!

If I had asked people what they wanted, they would have said faster horses - Henry Ford

Feb 15, 2011

This is the worst idea ever. If you have to approve trades through a compliance department, this will raise eyebrows so high your office might need a new roof- seriously if you pull this at an IB, you will likely be fired or put on some sort of probation. Even if you don't, most ETF's have many components- shorting every ETF component aside from the target security would take forever, would cost a fortune in both transaction fees and capital, and do you really think someone shorting a boatload of stocks at a time, especially in a single sector, isn't going to attract any notice?

WSO should not be posting crap like this. First of all it is unethical, if not illegal, and this will quickly land WSO on Websense's blacklist, making it inaccessible from your target audience. Second, this doesn't even pass the smell test- The pop on the single stock would have to be enormous to cover all of those transaction fees.

Feb 15, 2011
someotherguy:

WSO should not be posting crap like this. First of all it is unethical, if not illegal, and this will quickly land WSO on Websense's blacklist, making it inaccessible from your target audience. Second, this doesn't even pass the smell test- The pop on the single stock would have to be enormous to cover all of those transaction fees.

You're a fucking idiot. Of course its illegal. This is what a lot of the guys that got caught for insider trader were accused of doing. Regardless of your 'smell test' (and I'm sure you have had your nose in some pretty gross places) this does happen so, though you might think you're smarter than everyone else, you aren't.

If I had asked people what they wanted, they would have said faster horses - Henry Ford

Feb 15, 2011
HPM:
someotherguy:

WSO should not be posting crap like this. First of all it is unethical, if not illegal, and this will quickly land WSO on Websense's blacklist, making it inaccessible from your target audience. Second, this doesn't even pass the smell test- The pop on the single stock would have to be enormous to cover all of those transaction fees.

You're a fucking idiot. Of course its illegal. This is what a lot of the guys that got caught for insider trader were accused of doing. Regardless of your 'smell test' (and I'm sure you have had your nose in some pretty gross places) this does happen so, though you might think you're smarter than everyone else, you aren't.

title, deed, ownership, good day to you, sir, comma, comma, comma

Feb 15, 2011
someotherguy:

Even if you don't, most ETF's have many components- shorting every ETF component aside from the target security would take forever, would cost a fortune in both transaction fees and capital, and do you really think someone shorting a boatload of stocks at a time, especially in a single sector, isn't going to attract any notice?

To your first point, most ETFs contain a lot of different companies, but holdings are usually concentrated in a few. So you wouldn't actually have to short every single company in the ETF though this admittedly leaves you exposed to some risks. As long as the stock you have insider information on is a significant holding in the ETF then this would probably work.

As for attracting attention, I'm not saying I'd want to take the risk, but insider trading is so extremely common it's quite unbelievable... if you take a look at M&A announcements you almost always see activity in the stock & options markets BEFORE the announcement is made. Sometimes its plainly obvious it's insider trading. Case-in-point, the Friday before MEE announces it was being acquired the shares popped. The 65 strike calls traded extremely actively (stock opened at $55 on Friday so option was way OTM), with volume > open interest, almost twice if I remember correctly. And this is not an isolated incident. I'm not sure the SEC has done anything about this or that they will, too busy surfing porn perhaps. Prosecuting hedgefund traders is just good optics for them.

Feb 15, 2011

comment withdrawn

Feb 15, 2011

i thought this was about strippers... and so did the guy who just walked by my computer... thank god it's not

Feb 15, 2011
someotherguy:

This is the worst idea ever. If you have to approve trades through a compliance department, this will raise eyebrows so high your office might need a new roof- seriously if you pull this at an IB, you will likely be fired or put on some sort of probation. Even if you don't, most ETF's have many components- shorting every ETF component aside from the target security would take forever, would cost a fortune in both transaction fees and capital, and do you really think someone shorting a boatload of stocks at a time, especially in a single sector, isn't going to attract any notice?

You're missing the point. We're not talking about the guy in IBD or working S&T. This will never work for them because of other rules and regs. We're talking about the guy who is a hedge fund manager that is trading for his firm via multiple accounts across the street.You really think they have "Compliance" to check with? You really think that the guys who trade on insider information all work at Broker/Dealers and major banks? Nope. Not true. When you have a massive bankroll and margin to use, you can do this much easier than you think.

Also, what's wrong with discussing this? You're talking about problems in the field directed at your target audience so they know what not to do. If Wall Street were ethical, we wouldn't be in this problem in the first place, as we would all be happy people that understood to live within our means, not be motivated by the greed to provide the consumers with the foulest shovelable shit there is and then trade against it to make profit. The reason why we talk about what's illegal is so we learn from our mistakes. And no, this won't land WSO on the Websense Blacklist.

Feb 15, 2011

Good read, thanks for the breakdown. While a combination of short/long ought to make your net in favor of the stock you have information on, wouldn't the transaction costs of shorting every other component mitigate any reasonable gains? Unless the thing were to absolutely blow the fuck up I can't see this being sustainable.

Feb 15, 2011

As far as transaction costs, I think you have to remember that these guys (at least in the cases I know of) were managers of rather large funds. As such, they were able to put pretty huge amounts of capital behind these trades. So yes, transaction costs would be a consideration but you could also view it from their perspective in that these trades were 'guaranteed winners' so the relatively small transaction costs would be defrayed by the (perception) of big time gains.

If I had asked people what they wanted, they would have said faster horses - Henry Ford

Feb 15, 2011

If you had a guy at iShares or State Street pitching 5-stock ETFs for you, this could almost work. Good read, but really impractical and I wouldn't be surprised if the law caught up with this.

Best Response
Feb 15, 2011

I think you would be better off if you contact an EQDeriv/structured products desk of Bank A to structure you an option (rainbow, basket, whatever works) that gives you effective long exposure on 4 stocks, then contact Bank B sales desk and have them structure a option on the basket that gives you short exposure on the same stocks except the one you really want to trade. Then structure a variance swap with a Bank C on the 4 stocks to hedge your vega exposure (because you are effectively buying a straddle on the 3 irrelevant stocks by buying a call basket and a put basket).

With all these combined, you are

Long 4 stocks with A
Short 3 stocks with B
Long Vol with Bank A,B (Vega on the options)
Short Vol with Bank C

This would give leave you effectively long 1 stock with no other exposures. A lot less fees, much harder to track, a lot less transactions.

Alternatively, to make it even simpler, you can actually
Buy a 4-stock basket call with Bank A
Sell a 3-stock basket call to Bank B
So the vol exposure on the 3 irrelevant stocks cancel out, leaving you with long vol in the stock that you have insider info on. All you would then have to do is directly sell a straddle on that stock in the market to hedge the only vol exposure left. (this would help you hide your ultimate motive even better, who would short straddle if they are expecting news based on their insider info?)

    • 2
Feb 15, 2011

bearcats,

Believe me, there's plenty of that stuff going on. ETF stripping is sort of a "poor man's" derivative method of achieving the same end. But structuring it with SWAPS and other exotic derivatives is a more effective (and diabolical) way to do it. Very hard for the regulators to track, which is why people are doing it I suppose.

Feb 15, 2011

In order for this to work it would need to be on a company that was a major component of an ETF (Exxon for example), but even then the basis risk is HUGE.

Also, I am pretty sure that the CDS guy is still in court. His trade highlighted an important topic--using insider info in an unregulated over the counter market like CDS--legal or illegal?

Feb 15, 2011
Gekko21:

In order for this to work it would need to be on a company that was a major component of an ETF (Exxon for example), but even then the basis risk is HUGE.

Also, I am pretty sure that the CDS guy is still in court. His trade highlighted an important topic--using insider info in an unregulated over the counter market like CDS--legal or illegal?

That prosecution is a waste of money.

I am not cocky, I am confident, and when you tell me I am the best it is a compliment.
-Styles P

Feb 15, 2011

Why are you bumping a thread someone just commented on?

If I had asked people what they wanted, they would have said faster horses - Henry Ford

Feb 15, 2011
HPM:

Why are you bumping a thread someone just commented on?

oops.....fixed

Feb 15, 2011

Also, we are ignoring transaction cost's

Feb 15, 2011
Commodity Bull:

Also, we are ignoring transaction cost's

Yea dude, they've only been mentioned like 6 times already

If I had asked people what they wanted, they would have said faster horses - Henry Ford

Feb 17, 2011

has anyone thought of using CFD's trade insider information, I really do think it might work, plus its loosely regulated...
NB- you can't trade CFD's on US stocks...

Mar 19, 2016

Anyone else love the new TV show 'Billions'?

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Mar 19, 2016
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Mar 21, 2016

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