Informed options trading prior to the FDA approval

FDA approval of new drugs, devices and vaccines

New drugs, devices, and vaccines undergo rigorous testing before being made available to the public. Testing begins with pre-clinical tests on animals. Subsequently, a manufacturer can submit an investigational new drug application (IND) to the FDA. The IND will contain detailed information about the proposed drug and the proposed human clinical trials. The next stage consists of three clinical phases where the proposed drug is tested on humans, with the goal of understanding the success of the drug in treating public health. If a new drug has succeeded in passing these pre-clinical and clinical tests, a manufacturer can submit a new drug application (NDA) to the FDA. Through the NDA, the FDA assesses all aspects relating to the drug’s ability to treat a disease, its safety and side effects, and even its manufacturing process. The FDA’s approval of the NDA allows the manufacturer to market the new drug. The FDA will confidentially notify the manufacturer of its approval decision. As a result of this process, multiple individuals employed by the FDA and the manufacturer will be privy to this deliberately non-public material information. Until the FDA’s approval decision is announced to the public, it is during this time period that illegal informed trading can occur.

Informed trading in options markets

Stock options are financial derivatives whose value depends on the stock price itself. Options provide leverage to traders, as they allow traders to get a piece of the action at a price which is usually less than buying the stock itself. Traders use options for many reasons including: speculation (ie, betting), hedging (ie, protecting their portfolio value), and arbitrage (ie, locking in risk-free profits). Options are also used for illegal insider and informed trading on price-sensitive confidential news (eg, prior to news about mergers, earnings, commodities; see Bohmann et al., 2019; 2019a; 2020; Patel et al., 2020; 2020a). Several instances of illegal insider trading in stock and options on non-public FDA news have been detected and prosecuted by the United States Securities and Exchange Commission (SEC). The prosecution cases available on the SEC’s website show that illegal insider trading on FDA news is undertaken by company insiders, regulatory staff, and by individuals connected to them. Such individuals generate large profits from trading stocks and options.

Findings

In their 2022 study, Bohmann and Patel use three different ways to measure informed trading in options markets, including: options trading volume, implied volatility spreads and order imbalance. These measures have been found to capture the trading direction and intent of informed options traders, for example, for good news which causes stock prices to increase, informed traders will buy call options which will cause implied volatility spreads and call order imbalance to increase. Indicative of informed options trading, the authors find that options trading volume, implied volatility spreads and order imbalance are significantly elevated in the five-days preceding the FDA approval decision, and that such options trading activity can predict the stock returns on the FDA approval date.

Furthermore, these effects are magnified in manufacturers who are smaller in size and who have weaker corporate governance quality. This is consistent with informed traders having a greater information advantage over other investors in smaller stocks where it is harder to get meaningful information about its stock price, and in manufacturing companies where non-public material information is more likely to be leaked to individuals who are connected with them. Collectively, these results indicate that illegal insider trading on non-public FDA news occurs in options markets.

Implications

The UTS researchers report evidence of informed and illegal options trading prior to FDA approvals during a recent 21-year sample period. Persistent illegal trading in financial markets is concerning for regulators, manufacturers and investors, as it suggests that financial markets are not fair, and this can have adverse effects on market liquidity and an individual’s confidence and willingness to participate. Information leakage of non-public information also indicates that the corporate governance principles of drug manufacturing companies are not working as they should, and should be reviewed to prevent further information leakage.