Testing the Information-Based Trading Hypothesis in the Option Market: Evidence from Share Repurchases

Badshah Badshah,Kolari Kolari,Koerniadi Koerniadi

doi:10.3390/jrfm12040179

Abstract

The informed options trading hypothesis posits that option prices lead stock prices. In this paper, we extended the research on this hypothesis to open-market share repurchases. Empirical tests showed that the implied volatility spread was not significantly related to buy-and-hold abnormal stock returns. However, further evidence reveal a significant relationship between implied volatility spread and subsequent stock return volatility around open-market share repurchase events. We concluded that option traders have private information on the volatility of stock returns and superior information processing ability that accounts for prescient pricing behavior in options relative to stocks.

Highlights

Prior research suggests that informed traders prefer to trade options over stocks due to relatively lower trading costs, higher leverage, limited downside risks, volatility trading, and short sale access
Our results showed that volatility spreads are significantly related to stock return volatility for selected motivations to launch open-market repurchase programs, which suggests that informed trading occurs in these particular open-market repurchase programs
Prior studies suggest that informed investors prefer trading in option markets rather than in stock markets

Summary

Introduction

Prior research suggests that informed traders prefer to trade options over stocks due to relatively lower trading costs, higher leverage, limited downside risks, volatility trading, and short sale access (see, e.g., Black 1975; Easley et al 1998). Testing for volatility-informed trading in the option market before and after share repurchase announcements is important due to the fact that these events are, on average, positive return events but lower in return magnitude relative to other corporate events It is more suitable for informed option investors to use the option/underlying strategy, by including a long call option in their option trading strategy. These insignificant relationships are not surprising in view of the relatively small magnitude of short-term (long-term) announcement returns, i.e., on average only 1.20% (0.15%), respectively This finding is consistent with Badshah et al (2019), who documented the absence of directional informed trading in option markets prior to open market share repurchase announcements after the enactment of the SOX in 2002. We concluded that options trading around unscheduled open-market stock repurchases is predictive of stock return volatility

Hypotheses and Research Design

Sample

Results

Conclusions