GIK Institute of Engineering Sciences and

Technology Swabi, KPK

Financial Risk Management Time: 1 Hour
Quiz 02, Date: Marks: 20
Name: Usaeed Ullah
Reg no: 2020504
Case: Option Greeks, Insider Trading, and the Heinz Acquisition

Question 01:
When does trading qualify as insider trading? How would you recognize insider trading?
What are different strategies that could be used to take advantage of superior information?
Ans: Insider trading occurs when someone buys or sells a security while possessing non-public,
material information about that security. This can include:
 Executives or employees of a company trading their company's stock based on
confidential information.
 Friends or family members of company insiders who receive tips.
 Professionals like lawyers, bankers, or brokers who trade based on confidential
information obtained through their work.
For insider trading to be illegal, it must involve:
1. Material Information: Information is considered material if its disclosure could
reasonably be expected to affect the stock's price.
2. Non-public Information: The information has not been made available to the public.
3. Breach of Duty: The trader must have breached a duty of trust or confidence by using
the information.
How would you recognize insider trading?
Recognizing insider trading involves identifying suspicious trading patterns, particularly:
1. Unusual Trading Volume: Large, unexplained spikes in trading volume, especially
shortly before a major announcement.
2. Price Movements: Significant changes in the stock price without corresponding public
news.
3. Trading in Derivatives: High activity in options, particularly those that would benefit
from a known upcoming price movement.
4. Timing: Trades occurring shortly before an announcement that affects the stock price.
Different Strategies to Take Advantage of Superior Information
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Insiders might use several strategies to capitalize on their non-public information:
1. Direct Stock Purchases/Sales: Buying or selling stocks outright, which is the most
straightforward but also the most detectable method.
2. Options Trading: Using call or put options to gain leverage.
 Buying Calls: Profits from a price increase.
 Buying Puts: Profits from a price decrease.
3. Spreads: Combining multiple options strategies to hedge or amplify gains.
 Bull Call Spread: Buying calls at a lower strike price and selling calls at a higher
strike price.
 Bear Put Spread: Buying puts at a higher strike price and selling puts at a lower
strike price.
4. Straddles and Strangles: Positions that profit from large price movements in either
direction.
 Straddle: Buying both a call and a put at the same strike price.
 Strangle: Buying a call and a put with different strike prices.

Question 02:
If the insider trader had only a limited amount of capital available, would that effect their
decision? Which strategy would deliver the most “bang for the buck”?
Ans: With limited capital, an insider trader would seek to maximize their return on investment,
focusing on strategies that provide the most leverage and potential profit relative to the amount
of capital invested. This often means prioritizing options over direct stock purchases due to the
lower upfront costs and higher potential returns.
Strategy Delivering the Most “Bang for the Buck”
The most effective strategies for limited capital include:
1. Buying Call Options: If the insider expects the stock price to rise significantly after the
announcement, buying call options would provide high leverage. For example, buying
out-of-the-money calls, such as the June 2013 calls with a strike price of $65, which were
relatively cheap (offered at $0.40), could result in substantial returns if the stock price
rises above the strike price significantly after the announcement.

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 2. Bull Call Spread: To control risk while still gaining leverage, the trader might use a bull
call spread. For example, buying calls at a $60 strike price and selling calls at a $65 strike
price, thereby reducing the net cost of the position.
3. Straddle: If the trader anticipates a large price movement but is uncertain of the direction,
purchasing a straddle (buying both a call and a put at the $60 strike price) could be a
profitable strategy. This strategy benefits from significant volatility, which is expected
around major announcements.
Among these, buying call options generally offers the highest leverage for a rising stock price
scenario. For instance, with limited capital, purchasing out-of-the-money calls like the $65 June
2013 calls at $0.40 each can provide a substantial return if the stock price rises significantly
above $65. This strategy leverages the limited capital to maximize potential gains from superior
information about the impending price increase.