Surge in Trading of FHP Options Prompts Inquiry

The Chicago Board Options Exchange said Thursday that it is investigating unusually heavy trading of FHP International Inc. options in the days leading up to the announcement of its purchase by PacifiCare Health Systems Inc.

Nearly 10 times the usual volume of trades was recorded just two trading days before the Orange County companies went public with the merger news Aug. 5. That flurry of activity has sparked concern among some market watchers about potential abuse of insider information.

“We have opened a routine inquiry,” said Pat Campbell, spokeswoman for the CBOE, the nation’s largest options exchange. “That is our standard response any time there is a situation like this.”

Ria Carlson, spokeswoman for Fountain Valley-based FHP, said regulators have not informed FHP of any investigation. She said company officials are uncertain about what caused the spike in the trading of FHP call options.

“There were a lot of people involved in this deal outside FHP,” Carlson said. “We have no idea what happened here.”

Call options give investors the right to buy shares in a company at a specified price by a certain time. Investors who purchase stock options are betting that the price of the stock will rise above the purchase price agreed upon in the options contract.

On Aug. 1, investors purchased more than 2,000 FHP call option contracts, some of which gave buyers the right to purchase FHP stock for as low as $25 a share before Aug. 17. On Aug. 2, the last trading day before the merger was made public, 756 option contracts were purchased. Previously, trading volume in FHP options averaged about 200 contracts daily, according to Larry McMillan of McMillan Analysis Corp., a New Jersey company that tracks options trading.

Cypress-based PacifiCare announced Aug. 5 that it would purchase FHP for $2.1 billion, or $35 a share. FHP stock closed at $35.25 on the day of the announcement, resulting in profits as high as 41% for some investors who had purchased FHP call options just days before.

McMillan said prices for call options increased dramatically in the days leading up to the announcement, a sign that some investors moved aggressively to take a position in FHP stock.

“Somebody knew something,” McMillan said. “That’s obvious.”

But whether that knowledge was the result of illegal insider information remains to be seen. Industry watchers say the CBOE and other exchanges routinely investigate trading irregularities, many of which have nothing to do with illegal activity.

Bob Rack, research manager for the Investment Research Institute in Cincinnati, said hearsay and herd mentality may have motivated some investors to purchase FHP options.

“Theoretically, someone who saw the volume surge could have taken a flier,” Rack said. “A lot of people react to technical indicators.”

Analysts say the CBOE probe should have no effect on the pending merger. Investors caught using insider information typically are forced to surrender their profits and pay a fine. Jail sentences are rare.