Option Prices Leading Equity Prices: Do Option Traders Have an Information Advantage?

Abstract

Recent evidence shows that option volatility skews and volatility spreads between call and put options predict equity returns. This study investigates whether such predictive ability is driven by option traders' information advantage. We examine the predictive ability of volatility skews and volatility spreads around significant information events including earnings announcements, other firm-specific information events, and events that trigger significant market reactions. Consistent with option traders having an information advantage relative to equity traders before information events, we find that the option measures immediately before these events have higher predictive ability for short-term event returns than they do in a more dated window or before a randomly selected pseudo-event. We also find that option measures have predictive ability after information events. However, this predictive * Quantitative Management Associates; † Stern School of Business Administration, NYU; ‡ Columbia Business School. ability holds only for unscheduled corporate announcements, which suggests that, relative to equity traders, option traders have superior ability to process less anticipated information.

What do we know about individual equity options?

“…In a similar spirit, Van Buskirk (2011) finds that the skewness of the risk-neutral distribution has significant ability to predict future stock returns, but only in relatively short windows around earnings announcements. This ability of the skewness of the risk-neutral distribution to predict future stock returns is further confirmed by Xing et al (2010), Jin et al (2012), X. Liu et al (2014), andFu et al (2016).…”

“…They show that such deviations are significantly related to future stock returns, with stocks with relatively expensive calls outperforming those with relatively expensive puts. Furthermore, Jin et al (2012) show that the forecasting power of deviations from put-call parity is particularly high during important firm-specific information events. Borochin and Yang (2017) argue that the predictive ability of the skewness of the risk-neutral distribution and deviations from put-call parity stems from the fact that they reflect anticipated future net leverage changes which, in turn, impact future stock returns.…”

Informed Options Trading Prior to Dividend Change Announcements

“…Cremers and Weinbaum (2010) also show significant stock return predictability of implied volatility spread. Prior empirical studies also provide evidence that informed traders trade in options markets before corporate news events, such as analyst recommendations (Hayunga and Lung, 2014), merger and acquisition announcements (Augustin, Brenner, and Subrahmanyam, 2015;Cao, Chen, and Griffin, 2005; Chan, Ge, and Lin, 2015; Jayaraman, Frye, and Sabherwal, 2001), earnings announcements (Jin, Livnat, and Zhang, 2012), and share repurchase announcements (Hao, 2016). Findings of these studies suggest that option traders have an information advantage relative to equity traders before informational events.…”

“…Findings of these studies suggest that option traders have an information advantage relative to equity traders before informational events. Informed options trading, measured by, for example, implied volatility spread and volatility skew, has been shown to have predictive power for abnormal return around informational events (Chan et al, 2015;Hao, 2016;Jin et al, 2012).On the other hand, other studies indicate that options trading does not contain private information that predicts future stock prices. Chan, Chung, and Fong (2002) find that after controlling for stock trading volume, options trading volume has no incremental predictive power for underlying stock returns.…”

“…Findings of these studies suggest that option traders have an information advantage relative to equity traders before informational events. Informed options trading, measured by, for example, implied volatility spread and volatility skew, has been shown to have predictive power for abnormal return around informational events (Chan et al, 2015;Hao, 2016;Jin et al, 2012).…”