The National Post Online
Did terrorists short the market?
Regulators investigating: Findings may put a new, macabre spin on front-running
Stock markets in the United States reopened last week, but the anticipated "patriot rally" never materialized.
After a dramatic late rally on Wednesday took stocks well off the bottom, the selloff resumed on Thursday and Friday, as a wide range of companies related to the travel industry, including airlines, hotels, travel agencies and aircraft makers, announced large layoffs.
By week's end, the Dow had reached its lowest level since autumn, 1998, and its 14.4% decline for the week was one of the largest in history -- even worse than that recorded for the week ended Oct. 23, 1987 which included the Oct. 18, 1987 crash.
The U.S. Securities and Exchange Commission and the Chicago Board Options Exchange and other markets and regulators abroad are investigating trading patterns in airline, insurance and other sector stocks and options prior to the terrorist attacks.
The investigation will focus on traders who sold short or bought put options on such stocks. Short selling means selling stocks you don't own, hoping to buy back at a lower price. Put options represent the right to sell the underlying stock at a fixed price.
Short sellers and owners of put options profit when the underlying stock falls.
The investigation puts a new and macabre spin on the trading abuses known as front-running and self-front-running. Front-running is trading on the basis of information you have received. For example, a broker knowing that a client is about to buy a large block of stock, buys for his own account in advance of the order. Or a company insider knowing that a company is about to release a weak earnings report sells in advance of the news release. Self-front-running is trading in advance of an event that you are creating yourself.
An example of self-front-running is the trader who buys index put options and then sells short specific physical stocks in order to move the market down and profit from the highly leveraged put options. The analogy to the possible trading prior to the attacks is obvious.
At this stage, the possibility that terrorist leaders may have been selling short shares or buying put options is strictly speculative.
It is customary for stock or derivative exchanges and/or security regulators such as the SEC to investigate unusual trading activity and trading in period prior to any important event, earnings report or takeover.
However, as the investigations proceed, any findings would have interesting implications both in terms of the diagnostic information that may be revealed about the terrorists and whether financial markets were, and are, being used to help finance future such operations.