When a Politician Buys Options You Can Be Certain They Are Breaking the Law!

By Adam R. Dresher

When you hear of a politician buying options and making a profit, one should not laugh, one should not shrug, but rather steam should come out of your ears in anger! You can be near certain they are trading off inside information. Not only is trading off inside information illegal, but it is also what James Comey (86 47) used to prosecute billionaire Martha Stewart which landed her in jail for 5 months. It was considered serious enough to put a billionaire away for 5 months for avoiding a $45k loss, yet when a politician does it, CRICKETS! When a politician buys options, they are literally taunting us, yet not one politician has ever spent a day behind bars for insider trading.

So, what are options? In the simplest of definitions, an option is the right to buy or sell a stock for a certain price by a certain time. A call is the right to buy a stock by a certain time for a certain price (you call the stock away from someone) and a put is the right to sell the stock to someone by a certain time at a certain price (you put the stock to them). The one thing that is key about options is they have an expiration date on them, if they are not profitable by a certain date you are out of luck, however at any time before the expiration one can sell them or exercise them. In my twenty-year Wall Street career, I traded millions of option contracts and saw investors use them in numerous investment strategies. On my bookshelf, in my business section I have three textbooks on options each well over a thousand pages, while challenging, I will do my best to explain their purpose, benefits and why it is not a red flag but rather tsunami sirens going off when an elected official purchases them in their portfolio as briefly as possible.

First a quick history lesson. Two economists, Fischer Black and Myron Scholes who would later win a Nobel Prize for their work, created a pricing model known as the Black Scholes. The price of an option is based on a myriad of factors. Let us start with the price of the stock, if a stock is trading at $50, the price of the $55 calls is going to be more than the $60 calls. The volatility, if a stock traditionally has big intraday price swings the options are going to be more expensive than those of a stock that has more narrow price swings. The time until an option expires weighs heavily on the price on an option. Let’s say it is June 25th and the stock is trading at $75, the August 80 calls are going to be less expensive than the December 80 calls since there are fewer days thus lower odds for the stock to reach $80 by the 3^rd Friday in August (when the August options expire). Other factors that determine the price of an option are the risk-free rate of return e.g., the rate of return on US treasury bonds; and since options do not adjust for dividends, if a company has announced a dividend or is expected to, the options would factor the dividend into the pricing. There are other factors as well which I will not get into since most of us do not have a PhD in math. There is a lot of math that goes into the pricing of options e.g., the delta, the gamma, etc. and lucky of us we have computers to calculate the Black Scholes model for us.

Now here is where things get even more interesting. If you wanted to buy 10,000 shares of Home Depot you would enter your order to buy 10,000 shares at a certain price and someone who currently owns the shares would sell them to you (or the trading platform you use e.g. E*Trade or Fidelity might sell you the shares short, meaning they do not own them but are willing to sell them to you since they think they can cover their short at a lower price). There are currently almost 1 billion shares of Home Depot outstanding, over 3mm shares trade a day, it would be easy for someone to buy 10,000 shares. If you wanted to buy calls in Home Depot, someone would have to literally create the options to sell them to you. Yes, options are created and there is no set number of contracts. There might be 100,000 open option contracts to purchase Home Depot July 380 Call and zero option contracts to purchase September 380 Calls. When an option trade is done, it is marked either opening or closing based on whether the account is opening a position or closing it out.

Who creates these options and why? There was once a time thousands of option traders on the floors of the American Stock Exchange, Chicago Board Options Exchange and other regional exchanges were willing to create options and take the other sides of trades. Today, primarily large financial institutions like JP Morgan and Morgan Stanley create options. Why do financial institutions create options? It is historically very profitable. Remember in math class when the teacher went over bell curve distribution? The first standard deviation from the center represents 68% of the data and the second deviation represents 95% of the data. The Black Sholes options pricing model represents one standard deviation.

Let us say Home Depot is trading at $380 on August 25th and you wanted to purchase the September $380 calls. The price of those calls may be listed as following bid $2.25 for 1000 and the ask $2.75 at 1000. A person or financial institution would be willing to buy 1000 Home Depot September $380 calls for $2.25 and some person or financial institution would be willing to sell 1000 Home Depot September $380 calls at $2.75. The Black Sholes model is designed that if you buy on the bid and sell at the ask you should make money 68% of the time. Those are excellent odds and done billions of times over the course of a year a financial institution will make a substantial amount of money and will easily be able to weather some occasional big losses when there is an unforeseen big news event that drives the stock sharply higher or lower. A vast majority of the time the financial institution will hedge the options position by either buying or selling short shares. But keep in mind, if an individual investor buys a call option and pays the offer price, they should lose money 68% of the time.

Now knowing that the odds of making money buying calls and puts at the offered price is sharply against you, one should ask, why would anyone trade options? A perfect example would be what happened in the Academy Award winning film Wall Street. In one of the great segments Michael Douglas’ character Gordon Gekko has his prodigy Bud Fox (played by Charlie Sheen) follow his archrival Sir Larry Wildman around Manhattan to see what he is doing. Gordon Gekko has a deep disdain for Larry Wildman. He claims he ripped a deal out from right underneath him and wants payback. He believes Sir Larry Wildman is in town talking to investment bankers since he is about to acquire a company and wants to know what company so he can make a profit and hurt his enemy by running up the price.

Bud Fox follows him around all day on his motorcycle and concludes Sir Larry Wildman is going to acquire Anacott Steel. What is the first order Gorden Gekko gives Bud Fox? It is to buy 1500 July 50 calls (each call option is the equivalent of 100 shares so this order would give Gorden Gekko the right to purchase 150,000 shares of Anacott Steel at $50). Notice the order to buy calls first, then start buying the stock. His instructions are to buy the stock 1000 shares at a time up to $50 after he buys the calls. So why does the Wall Street master of the universe Gorden Gekko want to buy the calls versus the stock? Let me do the math for you.

In the movie, the next day you see Anacott Steel opens at $46. Steel companies historically have low volatility and Gordon Gekko knowing that the news of Sir Larry Wildman acquiring Anacott Steel is imminent he would buy the options with the shortest duration, so he is not paying much of a premium for the time value. We never see what price he pays for the options but to keep the math simple, let us say he pays $1 for each call option. 1 option contract represents 100 shares so 1500 calls x 100 x $1 equals $150,000.

In the film, later that day Sir Larry Wildman learns of Gordon Gekko buying the stock and shows up at his Hampton’s house to discuss a tender offer for the shares. After some back and forth they agree to a price of $71.50. Gordon Gekko’s July 50 calls he purchased for $1 would be worth $21.50; his $150,000 investment would be worth $3,225,000 for a 2,050% return. We never learn how many shares of stock Gordon Gekko purchases, but to once again keep the math simple, let us say he purchases 500,000 shares at an average price of $48 (in the film he instructs Bud Fox to purchase shares up to $50). 500,000 x $48 is $24,000,000. When the shares got acquired at $71.50, his $24,000,000 investment would be worth $35,750,000 for a 47% return. In total he would have made $14,825,000 for an approximate 61% return, however, you can see the dollar for dollar return on the options was extraordinary.

Now for a non-fiction story about the option market and why politicians purchasing calls and puts should not sound alarm bells but tsunami sirens. In 2002 while sitting at my desk making calls, a colleague yelled aloud that someone just purchased 10,000 Adelphia Communications $2.50 for $1.50. The hedge fund manager spent $1,500,000 to make a max profit of $1,000,000 or a 67% return. The only reason someone would make this trade is if they thought or knew Adelphia Communications was going to go bankrupt. The stock was trading in the teens at that time. So, what happened? Not too long after that trade, the CEO of Adelphia Communications John Regis and several other family members were arrested for bank fraud, wire fraud and securities fraud. They were using the company as their personal piggy bank to the tune of $2.3B. The company filed for bankruptcy. I do not know who purchased the puts, or how they obtained that information. But clearly, they knew something nobody else did at the time and made a big profit.

Let us create another fictional situation involving an average person to show the risk reward of buying calls versus buying the stock. If you live in Scottsdale, Arizona there is a high-end mall called Fashion Square. Let us say you go there in December to do Christmas shopping and notice a new sneaker store with a long line. You are curious and decide to stand in line and see what all the fuss is about. You wait over an hour to get into the store and once you do you try on their sneakers and you are blown away. You love the way the sneakers look, and they feel better than anything you have ever worn. You talk to the owner of the store, and they tell you they have not seen sneakers sell like this since the original Air Jordans were banned by the NBA. You also learn that they plan to open 300 stores nationwide and another 100 worldwide in the next six months. You are so impressed by these sneakers and notice how popular they are with everyone in the story trying them on that you want to invest.

You go home and learn that the company is publicly traded, and the shares are trading at $10. You also look at the calls and see the September 10 calls are trading at $3. You have $10,000 you want to invest, and you must weigh the pros and cons of purchasing the stock versus calls. If you decide to purchase the stock, you can buy 1,000 shares at $10/share. If you choose to purchase the September 10 calls, you can purchase 33 contracts (each option contract equals 100 shares x 33 x $3 = $9,900). Now if the company takes off and the stock is $25 by the third Friday in September (options always expire the third Friday of the month of their expiration), if you bought the stock, you made $15,000 and you increased your money to $25,000. Now if you invested all your money towards purchasing calls your returns would be greater. Those calls you purchased for $3 would be worth $15 each. $15 x 33 x 100 equals $49,500. However, let’s say the stock performs well and is trading at $12 on the third Friday in September. If you purchased the stock, you would have made $2,000 representing a 20% return, which is excellent by any standard. But if you had purchased the September 10 calls, they would be worth $2 for a 33% loss.

Off all the types of financial institutions, hedge funds are the ones that use options the most. Many financial institutions have restrictions on how options can be used, however, not hedge funds. Hedge funds use options for a myriad of reasons. Options can be used to lock in profits, hedge long-term gains, use less capital when making a directional bet, you can also place a two way bet when you are expecting a large move but not sure if it will be up or down, etc.

One of the most important things to know about hedge funds is that they employee some of (perhaps most of) the smartest people on the planet. When I was just over one year out of college and between jobs a friend and mentor was able to get me an interview at a fund he had previously worked at as an analyst before leaving to be a portfolio manager at a larger hedge fund. I went into the interview expecting this to be the first of several interviews which would eventually lead to me getting hired. Well, I was in for a rude awakening.

The first question I was asked, “So when are you going to go back to school and get your MBA?” I was one year out of college and most MBA programs want to see at minimum two years of employment before they will consider your application, so I explained it that way. Well, his response was, “We usually higher one person every 12-18 months and they usually are MBA or CFA (Charter Financial Analyst, a test which one has to pass three parts and can only take each part once a year).” Not only did he have the CFA title, but he also had a law degree from Harvard. He worked 7 years at a top white shoe law firm in NYC and left a year or two before he would have made partner since the money was so much better on Wall Street. In case you are wondering, partners at the law firm he worked at make between $1mm-$3mm a year. He talked to me for about five minutes, gave me a tour of the office, handed me their marketing brochures and I never heard from him again (and yes, I did call him several times post our interview).

I read their marketing brochures on the subway ride home. Their semi-conductor analyst had a master’s in engineering from MIT, the medical device analyst had a MD from Duke, their software analyst had a master’s in computer science from Stanford, their financials analyst had an MBA from Wharton. You name the prestigious post graduate degree, someone at their fund likely had that degree hanging on their wall. That is true throughout Wall Street. A friend of mine who deferred medical school for a year and worked at what has become one of the largest hedge funds in the world told me that they would only interview people from select colleges (translation Ivy League or MIT, Cal Tech, Duke, Chicago, Stanford, Williams or Amherst), wanted to know your SAT score and you better be graduating at minimum magna cum laude. I checked their webpage; they boast that 78 of their professionals have a PhD and their employees speak 65 languages.

Why are hedge fund jobs so sought after? In 2024 the top 25 hedge fund managers each made on average $1.2B. As a comparison, the CEOs of the top Wall Street investment banks such as Goldman Sachs, Morgan Stanley, Citigroup and JPMorgan made $35mm-$40mm in 2024. While that it is an incredible amount of money, it would take the CEO of one of those top investment banks 30+ years of making $35-$40mm a year to make $1.2B.

Now going back to that fictional sneaker company, if a hedge fund was researching that company they likely would have their retail analyst meet the CEO and CFO at their headquarters, run several channel checks, have forensic accountants review all their filings such as their 10Q and 10K reports, visit the plant in China where the shoes are made, talk to the companies that supply the materials, use satellite imaging to see the trucks coming and going from that plant, speak with all the fashion magazine editors, talk to advertisers, check with both college and professional teams to see what players think about them, talk to all the sell side analysts who cover the stock at firms like Bank of America/Merrill Lynch and UBS to name a few. Once they are through researching the company, they are going to check the macro environment, some funds check the macro environment first. They are going to make sure consumer spending is and will remain strong. They will want to make sure interest rates are going to stay low, make sure credit card debt is currently manageable, check and see if wages are rising, and all other elements of the macro picture. Once a hedge fund uses all the brain power at their disposal and decide to invest in a company, most of the time they will purchase the stock versus options. Why? Options are that risky.

Most hedge funds get paid “2 and 20” which means they collect 2% of the assets under management the first trading day of the year and then collect 20% of the profits on the returns after the close of market the last trading day of the year. If a fund had $1B of assets under management and had a 15% return that year. They would make $20mm from the 2% of assets under management and another $30mm on the performance (20% of the $150mm profit) for a hefty $50mm in fees.

So, what am I getting at? Hedge funds who have the brightest people on the planet working for them, would rather buy the stock versus buying calls. There is a myriad of uses for trading options. However, if a hedge fund wants to take a size position in a company, they are going to buy the stock. The chance that the options expire worthless is just too great, even for the smartest minds who have done all the research and are certain the stock is going to rally big.

Now do you think for a second a politician would spend $250k, $500k or even a $1 on call or put options if they were not privy to inside information? Not a chance!

Adam Dresher was born and raised in NYC and has spent the vast majority of his career in the Financial Services and Real Estate sectors. He now resides in Scottsdale with his wife, daughter and two dogs.