Informed Trading in Stock and Option Markets

We investigate the contribution of option markets to price discovery, using a modification of Hasbrouck's (1995) "information share" approach. Based on five years of stock and options data for 60 firms, we estimate the option market's contribution to price discovery to be about 17% on average. Option market price discovery is related to trading volume and spreads in both markets, and stock volatility. Price discovery across option strike prices is related to leverage, trading volume, and spreads. Our results are consistent with theoretical arguments that informed investors trade in both stock and option markets, suggesting an important informational role for options.     

Intraday Price Change and Trading Volume Relations in the Stock and Stock Option Markets

This study investigates intraday relations between price changes and trading volume of options and stocks for a sample of firms whose options traded on the CBOE during the first quarter of 1986. After purging the price change series of the effects of bid/ask spreads, multivariate time-series analysis is used to estimate the lead/lag relation between the price changes in the option and stock markets. The results indicate that price changes in the stock market lead the option market by as much as fifteen minutes. The analysis of trading volume indicates that the stock market lead may be even longer.     

Earnings Announcements,Stock Price Adjustment,and the Existence of Option Markets

This paper employs a new approach to study the effects of option trading on the behavior of underlying stock prices. Extant research compares distributional properties of the stock price at two points in time divided by an event in the option market that might affect price behavior. As an alternative, we examine the stock price adjustment to the release of quarterly earnings using samples of firms with and without listed options. We find the two samples exhibit different adjustment processes, with the nonoption firms requiring substantially more time to adjust.     

Options trading volume and stock price response to earnings announcements

We examine the effect of options trading volume on the stock price response to earnings announcements over the period 1996–2007. Contrary to previous studies, we find no significant difference in the immediate stock price response to earnings information announcements in samples split between firms with listed options and firms without listed options. However, within the sample of firms with listed options stratified by options volume, we find that higher options trading volume reduces the immediate stock price response to earnings announcements. This conforms with evidence that stock prices of high options trading volume firms have anticipated and pre-empted some earnings information in the pre-announcement period. We also find that higher abnormal options trading volume around earnings announcements hastens the stock price adjustment to earnings news and reduces post-earnings announcement drift.     

Managerial Risk-Taking Incentives and Executive Stock Option Repricing: A Study of US Casino Executives

I examine the relation between managerial incentives from holdings of company stock and options and stock option repricing. Because options provide incentives to increase both risk and stock price, firms must realize that as options go underwater, executives might face incentives to invest in risky, negative NPV projects. Repricing may alleviate such incentives. I examine repricing activity by firms in the US gaming industry and find that risk-taking incentives from options are positively related to the incidence of executive option repricing. The results support the hypothesis that repricing assists firms in alleviating excessive risk-taking incentives of senior management.     

ARE PRICE LIMITS EFFECTIVE? EVIDENCE FROM THE ISTANBUL STOCK EXCHANGE

There is considerable discussion about controlling volatility by imposing price limits on asset prices. We examine the effects of price limits on a stock market by testing the volatility spillover, delayed price discovery, and trading interference hypotheses in a leading emerging market, the Istanbul Stock Exchange, which has a unique market microstructure as related to price limits. Our results support the volatility spillover, delayed price discovery, and trading interference hypotheses. We also show price locks at limits provide significantly stronger evidence regarding the effects of price limits than limit moves only. Finally, price limits have a significant effect on the stock market, casting doubt on their effectiveness.     

PROBABILITY OF PRICE REVERSAL AND RELATIVE NOISE IN STOCK AND OPTION MARKETS

In this paper we take a new approach to the study of the interrelation between stock and option markets by extending Stoll's (1989) model of cost components of the bid-ask spread to include an error component in prices. Building upon Stoll's estimates of the probability of price reversals, we determine which of the option or stock markets carries more noise. The empirical results indicate that option markets are noisier than stock markets. Such findings are consistent with the view that option markets serve as a testing ground for noisy new information because of their comparative advantage regarding transaction costs, liquidity, and potential leverage.     

STOCK PRICE DYNAMICS IN OVERLAPPED MARKET SEGMENTS: INTRA AND INTER-INDUSTRY CONTAGION EFFECTS

This study examines stock price dynamics of contagion effects in overlapping markets using an exponential ARCH (Autoregressive Conditional Hetero-scedastic) model. Specifically, the stock price dynamics among the oil and oil-related industries of the US are examined to see how stock price movements in one industry affect those of the related industries. The results suggest that when the amount of price innovations is larger than the expected amount, volatility of stock returns will be affected. The results further show that this influence comes from the oil-service industry and spreads to the oil industry and the gas industry. That is, inter-industry contagion effects do exist. In addition, when the firms of the oil industry are grouped into three size categories - large, medium and small - the results indicate that the source of contagion is from the large and the small oil firms. The influence of their price innovations spread to medium-sized oil firms, the oil-service industry and the gas industry. That is, the inter-industry and intra-industry contagion effects exist simultaneously.     

THE DESIGN OF MULTI-YEAR STOCK OPTION PLANS

Despite the explosion in the corporate use of stock options, the incentives created by stock options are not well understood by either the boards who grant them or the executives who are meant to be motivated by them. A major source of confusion stems from the corporate practice of using multi-year stock option plans. Such multi-year grants create subtle, potentially important links between current performance and future grants that can significantly dilute incentives for better performance.
For example, so-called "fixed value" plans provide very weak, even perverse, incentives ex ante since the value of future option grants is completely insulated from current performance. Under such plans, an executive's reward for superior performance is to receive fewer options, and to receive more options for substandard performance. In contrast, the fixed number plan creates an intrinsic link between changes in this year's stock price and changes in the value of future option grants.
The author also reports the findings of new empirical research that shows that stock option plans, taken as a whole, have a pay-to-performance correlation that is eight times stronger than that of salary and bonus. But, consistent with the analysis above, fixed value option plans have pay-to-performance that is only six times that of salary and bonus, as compared to ten times for fixed number plans.     

Volume,volatility and information linkages in the stock and option markets

This paper examines the relationship between option trading activity and stock market volatility. Although the option market is uniquely suited for trading on volatility information, there is little analysis on how trading activity in this market is linked to stock price volatility. The bulk of the discussion tends to focus on whether trading activity in the stock market is informative about stock volatility. To analyze the information in option trading activity for stock market volatility, a sample of 15 stocks with the highest option trading volume is selected. For each stock, it is noted that the trading activities in the put and call option markets have significant explanatory power for stock market volatility. In addition, the results indicate that the call option trading activity has a stronger impact on stock volatility compared with that of the put options. Our results demonstrate that information and sentiment in the option market is useful for the estimation of stock market volatility. Also, the significance of the effects of option trading activity on stock price volatility is observed to be comparable to that of stock market trading activity. Furthermore, the persistence and asymmetric effects in the volatility of some stocks tend to disappear once option trading activity is taken into account.     

The Interrelation of Stock and Options Market Trading-Volume Data

This research empirically investigates the relation between common stock and call option trading volumes. The paper hyothesizes and tests a sequential flow of information between the stock and option markets. If information trading for CBOE-listed firms is predominantly accomplished through option trading, then existing research methodologies may be biased against finding any significant economic consequences in those instances where option listing is an important variable. Results indicate that trading in call options leads trading in the underlying shares, with a one-day lag.     

Trading activity and bid–ask spreads of individual equity options

We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid–ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60–90 days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid–ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latter’s spread to narrow.     

An Empirical Examination of the Return Volatility-Volume Relation in Related Markets: The Case of Stock and Options

This paper empirically examines the impact of option trading on the relation between daily stock return volatility and stock trading volume. For a sample of firms for which options were newly listed on the CBOE from 1982 to 1985, the empirical evidence indicates that there is a structural shift in the relation after option trading is introduced. Also, the findings show that daily stock return volatility is significantly and positively correlated with contemporaneous option volume, but not one-day lagged option volume. These results suggest that contemporaneous option volume may be an important variable in modelling daily stock return volatility and heteroskedasticity.     

Executive compensation and informed trading in acquiring firms around merger announcements

This paper analyzes informed trading in acquiring firms through (stock) merger announcements. We show that pre-announcement abnormal option volumes in acquiring firms strongly increase ahead of a stock merger (by approximately 300%). Furthermore, we show that the direction of option trades (puts or calls) prior to an announcement can predict post-announcement stock returns. Our results also indicate that higher wealth-to-performance sensitivities of top executives are related to higher abnormal put than call option trading before stock merger announcements. Overall, our results support the view that top executives have a hedging motive. They tend to purchase protection against, e.g., confounding (negative) information policies and/or empire-building mergers with negative NPVs, in order to avoid short-term salary losses (lower bonuses, lower stock options, etc.).     

On the Distribution of CBOE Option Trade Prices Occurring Between Consecutive Stock Trades

This paper examines the volume distribution of option trade prices that occurs when the underlying stock price remains constant. The width of these option trade price bands provides direct evidence on the law of one price and the redundancy of options assumed in many option models. We find that index option bands are narrower than equity option bands. Furthermore, for both equity and index options, puts have narrower bandwidths than calls. In general, option price bandwidth is narrow and can be explained by the minimum price movement allowed by the Chicago Board Options Exchanges (CBOE). This supports the single price law and the redundancy assumption. The existence of bid/ask quotes on the option does not materially affect the above results although it does alter the frequency of multiple option trade prices for a given underlying stock price. We note that over 53% of option trading volume occurs without bid/ask quotes on the CBOE compared to less than 15% a decade ago. Our results suggest that the effective bid/ask spread on options is probably no larger than the minimum price movements allowed by the CBOE. Furthermore, the need for the liquidity services of market makers may be declining if the decline in quoting activity stems from cross trading (i.e. trades not involving market makers).     

Market illiquidity and bounds on European option prices

The paper analyses the impact of illiquidity of a stock paying no dividends on the pricing of European options written on that stock. In particular, it is shown how illiquidity generates price bounds on an option on this stock, even in the absence of other imperfections, such as transaction costs and trading constraints, or the assumption of stochastic volatility. Moreover, price bounds are shown to be asymmetric with respect to the option price under perfect liquidity. This fact explains, under some conditions, the appearance of a smile effect when the implied volatility is estimated from the mid-quote.     

STOCK PRICE AND DEGREE OF NEGLECT AS DETERMINANTS OF STOCK RETURNS

In prior research the neglected firm effect persists even after controlling for firm size. Several recent studies show that the size effect is a stock price effect. In the present study we investigate whether excess returns on neglected stocks are a manifestation of a stock price effect. Although material evidence supporting an independent neglected firm effect is still found, results are much weaker than in prior studies. Examining a large sample of New York Stock Exchange and American Stock Exchange stocks from 1977 to 1988, we find that both January and non-January months do not have a statistically significant neglect effect after controlling for a price effect.     

EARNINGS ANNOUNCEMENTS,QUALITY AND QUANTITY OF INFORMATION,AND STOCK PRICE CHANGES

We analyze the informational effect of earnings announcements on stock price changes. Although prior studies postulate that the direction and magnitude of earnings surprises contribute to abnormal stock price changes, we attribute earnings surprises and subsequent stock price changes to the quality and quantity of available information. If a stock is followed by many financial analysts, the amount of information available to investors contributes to higher quality information, which in turn is reflected by a small earnings surprise. Furthermore, we demonstrate that as the quality and quantity of information increase, stock prices adjust more quickly, which sheds additional light on the post-earnings-announcement drift issue. Finally, cross-sectional analysis reveals that the flow of information, as measured by the rate of trading volume changes, and the stock of information, as measured by the number of financial analysts, contributes significantly to the variations in excess returns and return volatility. Traditional variables, such as earnings surprises, earnings reporting lag, and firm size, do not perform well.     

The Effect of Exercise Date Uncertainty on Employee Stock Option Value

The IASC recently recommended that employee compensation in the form of stock options be measured at the 'fair value' based on an option pricing model and the value should be recognized in financial statements. This follows adoption of SFAS No. 123 in the United States, which requires firms to estimate the value of employee stock options using either a Black‐Scholes or binomial model. Most US firms used the B‐S model for their 1996 financial statements. This study assumes that option life follows a Gamma distribution, allowing the variance of option life to be separate from its expected life. The results indicate the adjusted Black‐Scholes model could overvalue employee stock options on the grant date by as much as 72 percent for nondividend paying firms and by as much as 84 percent for dividend paying firms. The results further demonstrate the sensitivity of ESO values to the volatility of the expected option life, a parameter that the B‐S model or a Poisson process cannot accommodate. The variability of option life has an especially big impact on ESO value for firms whose ESOs have a relatively short life (5 years, for example) and high employee turnover. For such firms, the results indicate a binomial option pricing model is more appropriate for estimating ESO value than the B‐S type model.     

SECURITIES PRICE EFFECTS OF UNIONIZATION LEGISLATION

Prior studies document that firms experience negative stock price effects in response to unionization. We study the economic effects of a radical change in unionization legislation in New Zealand and hypothesize that the stock price effect of unionization is a function of prior unionization status of firms. We provide evidence that legislative events that increase the likelihood of introducing more stringent legislation do not affect stock prices of high‐unionized firms, whereas low‐unionized firms are affected negatively and significantly. Legislative events that signal less stringent unionization legislation result in significant stock price increases for all firms.