Traders at Specialists DPM in Chicago felt special anguish on September 11, not just because they knew many of those killed in the World Trade Center attack. And not because they stood to lose nearly $1 million on UAL options they had sold. It was the sickening realization that the buyers may have been in league with the terrorists and profited from a prior knowledge of the attack.

Regulators are tracing profits from some suspiciously well-timed trades in options and stocks of companies that were likely to be adversely affected by the terrorist attacks. And while many of those transactions were legitimate, an executive with the firm that acts as specialist, or market-maker, in UAL options says, "I'm not a big believer in coincidences."

The Chicago Board Options Exchange, the nation's four other option exchanges, the SEC and the FBI are working together investigating a list of 38 stocks, multiple options and some Treasury bonds following the September 11 terrorist attacks. SEC Chairman Harvey Pitt mentioned option trades specifically in testimony to the House Financial Services Committee, saying, "We will do everything in our power to track those people down and bring them to justice."

But some options professionals say investigators should be scrutinizing the possibility that conspirators may actually have profited more from a plunge in the entire market -- not just specific shares.

The list of stocks whose trading patterns are being investigated includes the obvious, including United Airlines' parent UAL and AMR, American Airlines' parent, both of which had planes hijacked; insurers that might be liable for large claims; and brokers and other financial companies, such as Morgan Stanley, Merrill Lynch, and American Express, which dropped sharply in the wake of the attack.

Just how does the world's biggest investigation into options trading progress? "We're working with other agencies as to whether trading could have been the result of prior knowledge of the event," says Mary Bender, chief regulatory officer at the CBOE. "We've never really had anything like this," she says, adding that the option exchanges are "using the same investigative tools as we would in an insider-trading case. The point is to find people who are connected to these heinous crimes."

Exchanges routinely review trades that may signal someone knew in advance of events affecting a stock price. "There are definitely industries and option classes that are logical to look at," Bender says. "There might be others that aren't so obvious, although we can't say which those are."

Members of option exchanges are handing over information about large positions held by their customers. Those trades that meet criteria for size or unusual timing are tagged. Option exchanges will examine who held the contracts, whether the number increased over the time leading up to the attacks and whether the investors were first-time or returning customers, Bender explains. A newly opened account, or a first trade in airline options, for instance, might tip off regulators to something unusual.

Exchanges are also poring over "blue sheets," documents brokers must keep identifying customers with crucial information, such as a Social Security numbers and tax ID numbers. Authorities also are looking to bank accounts where any ill-gotten gains would be deposited. "If there's something there, we'll find it." Bender says. But she adds, "I'm not confident there's anything there."

While option exchanges are cooperating with federal authorities to find links in the financial markets to the terror attacks, what do the facts show? "All this finger-pointing after the fact is probably going to wind up going nowhere," says one dissenting option strategist who requested anonymity. "Most other option professionals do not think there was anything going on here, but for fear of reprisals by conspiracy theorists, they may not be willing to say so publicly." Others say investigators will find someone profited from the carnage -- but in a better hiding place. "You could have made a killing in S&P 500 index options," says Jon Najarian, head of Mercury Trading in Chicago.

For now, the SEC and FBI are focusing on the significant trades in individual put options, which give buyers the right to sell a stock at a specified price through a specified date. If the stock drops, the put holder profits. AMR and UAL shares plummeted nearly 40% the first trading day after the attacks. A UAL put that allowed the holder to sell at a fixed price of 30 increased about tenfold, from $1.50 on September 10 to $16 after trading resumed the following week as UAL shares collapsed to 17 from 30.

One large UAL put order was sent to the bustling CBOE floor in the days prior to September 11 by a customer of Deutsche Bank. The primary trading post for UAL expected to handle the whole 2,500-contract order. Instead, the customer split that into chunks of 500 contracts each, directing each order to various exchanges around the country simultaneously, according to people familiar with the trade. Moreover, some of the options have yet to be exercised, possibly because those customers' accounts have been frozen.

But some option veterans say there's nothing unusual about either the size or manner in which the order was handled. Options in UAL are heavily traded, usually by institutions hedging their stock positions. And UAL's share price had broken down enough to worry traders who follow chart patterns, and that may have increased put buying.

Activity in AMR options also isn't conclusive. The heaviest trading was not in the cheapest, short-dated puts that would have provided the biggest gains to a conspirator with foreknowledge of the events of September 11. Moreover, at least one analyst had issued a "sell" recommendation on AMR the previous week.

Finally, these and many other options had grown quite cheap in the weeks prior to the terrorist attacks -- another reason put buyers might have been legitimately attracted to them for insurance in the already uncertain market.

If a customer starts buying heavily, especially one who market-makers suspect has inside information, sellers will immediately raise their asking price. But they didn't, notes the dissenting option strategist. "That indicates to me that market makers in these options saw nothing unusual at the time." Moreover, the profits from suspicious individual option trades probably add up to only $10 million.

"I checked out the activity right away, and I don't believe" that there was insider trading going on in individual options, stresses Paul Foster, a trader and commentator with Beyond-TheBull.com in Chicago. "However, whoever did this had the scope to take advantage of moving the entire market." Indeed, the Standard & Poor's 500 plunged 11.6% in the week after the market reopened September 17.

So where should investigators be looking? The price action in the S&P 500 index options, specifically September 1100 S&P puts, was curious. Those options were "in the money," meaning they gave the right to sell at a price above the market -- but only until they expired in September. As they approach expiration, the price of such an option theoretically should fall to the difference between the strike price and the underlying index level. But for two weeks leading up to the attacks, the September 1100 index options stopped declining as theory dictates, indicating demand for those options remained inexplicably high.

Those index options rocketed from around $12 a contract to over $90 after the attack. Just 100 of those options would have netted $780,000, and thousands change hands on a typical trading day. "It wouldn't be that tough to build up a position of a few thousand of these contracts over a few days," Najarian says. "By then, you're getting into the tens millions of dollars pretty quickly."

So, as Deep Throat suggested in the Watergate scandal, maybe investigators should follow the money -- to the S&P index options.

(END) Dow Jones Newswires 10-06-01

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