Informational Content of Option Volume Prior to Takeovers

Abstract

This paper examines informed trading in the options versus the stock market prior to takeover announcements. Prior to an announcement, the percentage increase in call volume for target firms is roughly four times as large as the increase in stock volume. Moreover, preannouncement option volume is the heaviest in those takeover targets that experience the highest announcement-day returns. Short-term out-of-the-money calls experience the largest increase in buy-side trading, suggesting that the activity is dominated by those who are relatively certain an announcement will occur soon. We also use volume-triggered trading rules to further assess the relationship between call volume and future returns as well as the profitability of option trading prior to takeovers. Trading profits are increasing in the amount of call volume required to trigger a buy signal. However, similar trading rules using stock volume reveal no such patterns. When these trading rules are applied to all firms with options listed on the CBOE, large increases in call-option trading are again followed by higher subsequent returns. Our results indicate that between the options and the stock markets, informed investors prefer to trade on the former market. Thus, the options market is more conducive to information and price discovery. 1 known that when the underlying stock price follows a one-dimensional diffusion process, an option in a perfect-market environment can always be replicated by combining the underlying with a riskfree asset. In real life, however, information is often asymmetric (especially before major corporate announcements) and trading frictions (e.g. transaction costs, short sale and capital constraints) are abundant, making options non-redundant. For instance, Back (1993) shows that with asymmetric information option and stock volumes convey different information and thus it is not possible to replicate an option with the underlying stock. However, options are also generally associated with higher proportional transaction costs, less liquidity, and trading in options may be more transparent due to lower volume levels. Thus, it is an empirical question as to whether informed traders indeed prefer to trade in options. In the existing literature, several studies have examined the general question of whether options trading changes the informational efficiency of equity-related markets. For example, Klemkosky and

Are Corporate Spin-Offs Prone to Insider Trading?

“…According to Ou-Yang (2009) andJohnson andSo (2012), trading in options should be concentrated around information events. Finally, Cao, Chen, and Griffin (2005) show empirically that the options market displaces the stock market as a venue of informed trading ahead of M&As. In the context of SPs, the question of where informed investors trade is primarily an empirical one.…”

“…To provide just a few examples, there is abundant recent empirical evidence on informed trading ahead of earnings announcements (Kaniel, Liu, Saar, and Titman (2012), Kadan, Michaely, and Moulton (2014), Goyenko, Ornthanalai, and Tang (2014)), mergers and acquisitions (M&A) (Cao, Chen, and Griffin (2005), Chan, Ge, and Lin (2014), Augustin, Brenner, and Subrahmanyam (2014)), bankruptcies (Ge, Humphrey-Jenner, and Lin (2014)), the 9/11 terrorist attack (Poteshman (2006)), and leveraged buyouts (Acharya and Johnson (2010)). The question of where informed investors trade has also been studied extensively, from a theoretical perspective, taking into consideration asymmetric information (Easley, O'Hara, and Srinivas (1998)), differences in opinion (Cao and Ou-Yang (2009)), short-sale constraints (Johnson and So (2012)), or margin requirements and wealth constraints (John, Koticha, Narayanan, and Subrahmanyam (2003)).…”

“…1 While there is recent empirical evidence of informed trading ahead of corporate announcements such as earnings announcements (Kaniel, Liu, Saar, and Titman (2012), Kadan, Michaely, and Moulton (2014), Goyenko, Ornthanalai, and Tang (2014)), mergers and acquisitions (M&A) (Cao, Chen, and Griffin (2005), Chan, Ge, and Lin (2014), Augustin, Brenner, and Subrahmanyam (2014)), and bankruptcies (Ge, Humphrey-Jenner, and Lin (2014)), no such evidence exists for the period preceding corporate spinoff (SP) announcements, which pertain to the sale of a subsidiary or a division of a company as a separate entity. This is surprising since SPs are supposed to be publicly unexpected, and largely unpredictable, and the parent firm's stock price typically rises after the deal announcement (Maxwell and Rao (2003), Ahn and Denis (2004)).…”

The Information Content of Option Prices: Evidence from S&P 500 Index Options

“…Black (1975) and Easley, O'Hara and Srinivas (1998) argue that an informed trader would prefer to trade options to stocks because of options' leverage effect. Manaster and Rendleman (1982), Bhattacharya (1987), Amin and Lee (1997), Chan, Chung, and Fong (2002), Cao, Chen and Griffin (2005) and Pan and Poteshman (2006) find that some informed trades on options achieve excess rates of return and that option market quotes contain information about future stock returns. Meanwhile, Muravyev et al (2013) provide compelling evidence that option prices do not contain any significant information that has not already been reflected in the stock prices.…”

Trading in option contracts before large price changes: A comparative study of US and UK markets

“…Irrespective of the exact option strategy, the increased trading will result to increased call and put trading volume before the information is released (Jayaraman et al, 2001;Cao et al, 2005;Arnold et al, 2006). This article examines, for the first time, trading volume in individual stock option contracts before large stock price changes in the underlying stock and offers original comparative evidence for the US and UK markets.…”