Option Market Efficiency and Analyst Recommendations

Abstract

This paper examines the information content in option prices and volatility surrounding analyst recommendation changes. The sample includes 7,549 recommendation changes of optionable stocks over the period January 1996 to December 2005. As expected, mean underlying asset returns are positive on days of recommendation upgrades and negative on days of recommendation downgrades. However, option volatility prior to recommendation changes can explain a significant portion of corresponding underlying asset price changes. Additionally, forming long straddle positions prior to analyst recommendation changes results in a -16% mean return for downgrades and a -17% mean return for upgrades. Even if the directions of recommendation changes are known, significant returns cannot be earned by taking appropriate long positions in call or put options. Ex-ante price and volatility response in option markets are linked to an increase in jump uncertainty risk premia. The findings suggest information in option market prices and volatility leads analyst recommendation changes, meaning analyst forecast revisions do little to improve market efficiency.