ICT Consultant

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 Selling

Most 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 Markets

An 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 Trades

Certain 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:

• The timing is just a little too good.  Anyone can make an investment at any time, but someone who buys soon-to-be profitable put options or sells a stock short in the few trading days immediately before a major decline in the stock's price will seem to have been more than ordinarily lucky.  This criterion is suggestive when present, but is not mandatory.  For example, a short sale could have been made quite some time before it would turn out to be profitable.  But the longer in advance a short sale or put-option purchase is made, the more uncertainty there will be as to whether events will play out according to plan; so generally the inside trader doesn't make illicit trades very long in advance.

• The transaction itself is too specific.  For example, if someone bought puts on United Airlines and American Airlines but not on Delta Airlines, investigators will be pretty sure that the trader knew in advance that these two airlines were targets of the attack.  (On the other hand, this works both ways:  If there were similar trades in a third airline but not in others, investigators can conclude that one or more flights of that airline were supposed to have been hijacked as well.)

• The transaction is too large.  One of the most reliable indicators of illegal insider trading is that the perpetrator has traded at an abnormally high level.  In other words, someone who normally makes trades of a few thousand dollars now and then, but suddenly begins to make much bigger plays, may well be doing so because s/he has some form of inside knowledge.  If inside-traders kept their trades to reasonable levels, they would seldom, if ever, be caught -- since their trades wouldn't seem especially abnormal and they could be explained as part of their regular investment strategy.  However, people typically get caught up by their own greed:  when they know for certain that something significant is going to happen to the price of a stock, they can't resist the temptation to make as much money as possible on their knowledge.

• Transactions deviate from normal trading levels.  In the options markets, there is normally a reasonably even balance between call and put options on any given stock; and there is normally a reasonably predictable level of activity in options on any particular stock.  When the balance between puts and calls is grossly disrupted and the level of volume in options trading is far beyond normal, investigators can be pretty sure that something is up.

• The transaction is too speculative.  In other words, the transaction is one that would be unreasonably risky -- if not out-and-out stupid -- were it not that the perpetrator was trading based upon inside knowledge.  For example, a large purchase of stock options that were both significantly "out of the money" and relatively close to their expiration date, but suddenly turned out to be valuable based upon some news affecting the underlying stock, would seem to represent an unreasonable degree of prescience.

Investigators will be looking at transactions starting with those that can be most easily identified as suspicious.  Already enough has emerged to indicate that some trades were almost certainly made based upon advance knowledge of the Black Tuesday attacks:

• Between September 6 and 7, the Chicago Board Options Exchange saw purchases of 4,744 put options on United Airlines, but only 396 call options.  Although there was no news at that time to justify so much "left-handed" trading, United Airlines stock fell 42 percent, from $30.82 per share to $17.50, when the market reopened after the attacks.  Assuming that 4,000 of the options were bought by people with advance knowledge of the imminent attacks, these "insiders" would have profited by almost $5 million.

• On September 10, 4,516 put options on American Airlines were bought on the Chicago exchange, compared to only 748 calls.  Again, there was no news at that point to justify this imbalance; but American Airlines stock fell 39 percent, from $29.70 to $18.00 per share, when the market reopened.  Again, assuming that 4,000 of these options trades represent "insiders," they would represent a gain of about $4 million.

• No similar trading in other airlines occurred on the Chicago exchange in the days immediately preceding Black Tuesday.

• Morgan Stanley Dean Witter & Co., which occupied 22 floors of the World Trade Center, saw 2,157 of its October $45.00 put options bought in the three trading days before Black Tuesday; this compares to an average of 27 contracts per day before September 6.  Morgan Stanley's share price fell from $48.90 to $42.50 in the aftermath of the attacks.  Assuming that 2,000 of these options contracts were bought based upon knowledge of the approaching attacks, their purchasers could have profited by at least $1.2 million.

• Merrill Lynch & Co., with headquarters near the Twin Towers, saw 12,215 October $45.00 put options bought in the four trading days before the attacks; the previous average volume in these options had been 252 contracts per day.  When trading resumed, Merrill's shares fell from $46.88 to $41.50; assuming that 11,000 option contracts were bought by "insiders," their profit would have been about $5.5 million.

• European regulators are examing trades in Germany's Munich Re, Switzerland's Swiss Re, and AXA of France, all major reinsurers with exposure to the Black Tuesday disaster.  (Swiss Re estimates that its exposure will be $730 million; Munich Re expects to pay out as much as $903 million.)  It is not clear if any trades in these stocks ring alarm bells; and some negative earnings news announced shortly before the attacks means that a certain amount of unusual selling may have been a normal market reaction and not anything more sinister.

• Amsterdam traders have noted that there was unusual trading activity in KLM Royal Dutch Airlines put options before the attacks.

This is very much a developing story, and we can be sure that more -- and more accurate -- numbers will emerge soon.  Investigators will be examining transactions starting with the few days immediately before the attack, and then working backwards; and similarly, they will be looking first at trades in the most obviously affected securities.

Drawing Conclusions

Assuming 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.