The efficacy of regulatory intervention: Evidence from the distribution of informed option trading

A substantive body of equity-market academic research documents an extensive range of costs arising from the SEC’s October 2000 adoption of strictures on selective disclosure and insider trading; suggesting an unusual outcome, specifically, an increase in informed trading. We investigate the efficacy of the SEC’s regulations by examining informed trading in an attractive setting for exploiting private information; the options market. Using data on the S&P 1500 industrial firms, our analysis indicates that about 38% of firms exhibited symptoms of informed option trading prior to regulatory intervention. After regulatory intervention, we observe that only 19% of firms show symptoms of informed trading. In additional testing of ADR firms – explicitly exempt from complying with Reg FD, we find no evidence of a change in informed option trading from pre- to post-regulation; suggesting that the SEC’s strictures on US firms led a to a significant reduction in informed option trading. Notably, our proxies for large shareholder and financial analyst access are associated with the largest decreases in informed option trading. In developing a unique measure of informed trading based on option market data, we provide evidence on the efficacy of security regulation in limiting informed trading.     

Accounting quality,information risk and the term structure of implied volatility around earnings announcements

We examine the association between accounting quality, which is used as a proxy for firm information risk, and the behavior of the term structure of implied option volatility around earnings announcements. By employing a large sample of US firms having options traded on their equity during 1996–2010, we find that lower (higher) accounting quality is significantly associated with stronger (weaker) changes in the steepness of the term structure of implied volatility curve around quarterly earnings announcements. This finding (which is robust to controls for business-stemming uncertainty regarding future firm performance) is consistent with a stronger differential of short vs. long-term uncertainty for higher information risk firms, indicating greater uncertainty on the future economic performance of poorer vs. stronger accounting quality firms. We also establish the trading implications of these findings by demonstrating a (profitable in-sample) self-financed option trading strategy that is based on the quality of the accounting information released on earnings announcement days.     

Informed trading,information uncertainty,and price momentum

In this paper we investigate the effects of informed trading (PIN) and information uncertainty in determining price momentum. We find that trading strategies based on buying high-uncertainty good-news stocks and shorting high-uncertainty bad-news stocks work well when limited to high-PIN stocks, while stocks with low-PIN do not exhibit price continuations, even when the uncertainty level of those stocks is high. In contrast, momentum returns are always significant for high-PIN stocks, irrespective of information uncertainty. Overall, we show that the informed trading effect is both independent of and stronger than that of information uncertainty in determining price momentum.     

The relationship between the frequency of news release and the information asymmetry: The role of uninformed trading

This paper shows that the degree of information asymmetry is lower for firms with more frequent news releases. The relation holds for various measures of information asymmetry such as the probability of information-based trading (PIN), permanent price impact, and adverse selection component of bid-ask spread, even after adjusting for endogeneity between news release and information asymmetry. By decomposing the PIN into intensities of uninformed and informed trades, similarly to Brown and Hillegeist (2007), we find that intensity of uninformed trading increases much more than that of informed trading for firms with more frequent news releases. As a result, information asymmetry, as is measured by PIN, decreases for such firms due to the large increase in the intensity of uninformed trading. Our findings highlight not only the importance of news releases in leveling the playing field of investors but also the role of uninformed investors in reducing trading cost due to information asymmetry.     

Informed arbitrage with speculative noise trading

We consider speculative noise trading when some naïve speculators trade on noise as if it were information [Black, F., 1986. Noise. Journal of Finance 41, 529–543]. We examine the optimal trading strategy of an informed investor who faces such naïve speculators in the market. We find that the informed investor trades aggressively on her information and takes large, opposite positions against the naïve speculators. The trading volume is thereby drastically magnified. While such speculative noise trading enhances liquidity, it makes prices less efficient. The overall dynamic patterns that emerge from our model are most consistent with the evidence for interday variations in volume, volatility, and transaction costs.     

Aggregate insider trading: Contrarian beliefs or superior information?

We decompose realized market returns into expected return, unexpected cash-flow news and unexpected discount rate news to test the relation between aggregate market returns and aggregate insider trading. We find that (1) the predictive ability of aggregate insider trading is much stronger than what was reported in earlier studies, (2) aggregate insider trading is strongly related to unexpected cash-flow news, (3) market expectations do not cause insider trading contrary to what others have documented, and (4) aggregate insider trading in firms with high information uncertainty is more likely to be associated with contrarian investment strategy. These results strongly suggest that the predictive ability of aggregate insider trading is because of insider’s ability to predict future cash-flow news rather than from adopting a contrarian investment strategy. These results hold even after we control for non-informative trades and information uncertainty.     

Options trading activity and firm valuation

Options may have an effect on firm value because they help complete markets and stimulate informed trades. However, these benefits are likely to manifest themselves in active, rather than inactive, options markets. Supporting this observation, we find that firms with more options trading have higher values of Tobin's q, after accounting for other determinants of value. Corporate investment in firms with greater options trading is more sensitive to stock prices. Options trading affects firm valuation more strongly in stocks with greater information asymmetry. These results indicate that options trading is positively associated with firm values as well as information production.     

Feedback and the success of irrational investors

We provide a model in which irrational investors trade based upon considerations that have no inherent connection to fundamentals. However, trading activity affects market prices, and because of feedback from security prices to cash flows, the irrational trades influence underlying cash flows. As a result, irrational investors can, in some situations, earn abnormal (i.e., risk-adjusted) profits that can exceed the abnormal profits of rational informed investors. Although the trading of irrational investors cause prices to deviate from fundamental values, stock prices follow a random walk.     

Migration,spillovers, and trade diversion: The impact of internationalization on domestic stock market activity

This paper studies the relation between internationalization (firms cross-listing, issuing depositary receipts, or raising capital in international stock markets) and the trading activity of the remaining firms in domestic markets. Using a panel of 3000 firms from 55 emerging economies during 1989–2000, we find that internationalization is negatively related to the trading activity of domestic firms. We identify two channels. First, the trading of international firms migrates from domestic to international markets and this migration along with the reduction in domestic trading of international firms has negative spillover effects on domestic firm trading activity. Second, there is trade diversion within domestic markets as trading activity shifts out of domestic firms and into international firms.     

Local investors,price discovery,and market efficiency

This study examines the effect of locally informed investors on market efficiency and stock prices using large power outages, which are exogenous events that constrain trading. Turnover in stocks headquartered in an outage area with 0.5% of U.S. electrical customers drops by 3–7% on the first full day of the outage, and bid–ask spreads narrow by 2.5%. Firm-specific price volatility is 2.3% lower on blackout dates. This effect is larger for smaller, lesser-known stocks and in higher income areas. Consistent with a valuation discount and higher expected returns for stocks with more informed traders, firms with a one-standard-deviation higher local trading propensity have market-to-book values that are 5% lower, Tobin's Q that is 6% lower, annualized four-factor alphas that are 1.2% higher, and average spreads that are 6.5% higher. Together, the evidence suggests that informed investors contribute disproportionately to both liquidity and price discovery, and that these contributions are reflected in valuations and expected returns.     

What does PIN identify? Evidence from the T-bill market

The probability of informed trading (PIN) measure has been increasingly used in empirical research in finance. However, there is a growing debate as to whether PIN measures information-based or liquidity-based trading. We contribute to the discussion by estimating PIN using transaction data for one-month T-bills. Our PIN estimates exceed those reported for equities, despite it being unlikely that the probability of informed trading is higher in T-bills than equities. We conclude that PIN identifies trading clusters and that the source of the clustering depends on the economics of the market. The economics of the T-bill market suggest discretionary liquidity traders are the likely source of the clustering.     

Crises,contagion and cross-listings

We investigate whether cross-listing shares in the form of depositary receipts in overseas markets benefits investors in emerging market countries during periods of local financial crisis from 1994 to 2002. We regress cumulative abnormal returns for three windows surrounding the crisis events on the cross-listing status while controlling for cross-sectional differences in firm age, trading volume, foreign exposure, disclosure quality and corporate governance. Further, we examine cross-listing effects in countries popularly thought to experience contagious effects of these crises. We find that cross-listed firms react significantly less negatively than non-cross-listed firms, particularly in the aftermath of the crisis. The results on contagious cross-listing effects are however mixed. Our findings are consistent with predictions based on theories of market segmentation as well as differential disclosure/governance between developed and emerging markets. We do not find evidence that foreign investors “panic” during a currency crisis.     

Information, speed vs. cost trade-offs, and order routing decisions in U.S. equity markets

Prior research indicates that both execution speed and cost are important to traders, but that these two dimensions of execution quality are negatively related across U.S. equity markets. In our paper, we examine how U.S. equity traders, who are (un)informed about future price changes, trade-off between speed and cost in their order-routing decisions. We find that informed traders are more likely to choose trading systems that allow them to trade-off lower cost for faster speed; whereas, uninformed traders are more likely to choose trading systems that allow them to sacrifice speed for lower costs. Our results indicate that traders have varying preferences for the different dimensions of execution quality based on their information levels. These differences subsequently influence order-routing decisions.     

Which Institutional Investors Trade Based on Private Information About Earnings and Returns?

Recent work suggests that institutional investors execute profitable trades based on private information about earnings and returns. We provide new evidence on the prevalence and sources of such informed trading by (1) testing for the creation and liquidation of positions based on private information, (2) introducing private information proxies that reflect the size and nature of an institution's position in each portfolio firm, and (3) using a methodology that examines multiple investor characteristics simultaneously at the institution‐firm level. We find that changes in ownership by institutions with large positions in a firm are consistent with informed trading. However, other previously documented proxies for private information produce results more consistent with risk‐based trading (e.g., investment style) or insignificant in the presence of other proxies (e.g., fiduciary type). We also find that informed trading is more prevalent in small firms and when the large positions are taken by investment advisers and large institutions.     

Fuzzy logic,trading uncertainty and technical trading

From the market microstructure perspective, technical analysis can be profitable when informed traders make systematic mistakes or when uninformed traders have predictable impacts on price. However, chartists face a considerable degree of trading uncertainty because technical indicators such as moving averages are essentially imperfect filters with a nonzero phase shift. Consequently, technical trading may result in erroneous trading recommendations and substantial losses. This paper presents an uncertainty reduction approach based on fuzzy logic that addresses two problems related to the uncertainty embedded in technical trading strategies: market timing and order size. The results of our high-frequency exercises show that ‘fuzzy technical indicators’ dominate standard moving average technical indicators and filter rules for the Euro-US dollar (EUR-USD) exchange rates, especially on high-volatility days.     

When Analysts Talk,Do Institutional Investors Listen? Evidence from Target Price Changes

We find that institutions trade in the same direction as target price changes based on 6,415 U.S. firms from 1999 to 2011, even after controlling changes in stock recommendations and earnings forecasts. The impact of target price changes on institutional trading is more pronounced for small firms, firms followed by few analysts, and illiquid firms, and is mainly limited to transient institutions. We do not find any outperformance for institutions to follow analysts’ target price forecasts, suggesting that institutions could find it easier to justify their investment decisions by following analyst forecasts, although such trading does not result in outperformance.     

Information asymmetry, speculation and foreign trading activity: Emerging market evidence

This paper provides evidence on the relation between private-information-based trading and foreign trading activity on the Istanbul Stock Exchange (ISE). We use a recently developed model that utilizes information in volume-return dynamics of individual stocks and show that variables such as size and Tobin's Q explain the extent of speculative activity across firms traded on the ISE. We present evidence supporting the notion that foreign trading activity is associated with informed trading on the ISE. Implications of our findings for emerging markets research are also discussed.     

Does volume help in predicting stock returns? An analysis of the Australian market

This paper presents an analysis of the relationship between trading volume and stock returns in the Australian market. We test this hypothesis by using data from a sample of firms listed on the Australian stock market for a period of 5 years from January 2001 to December 2005. We explore this relationship by focusing on the level of trading volume and thin trading in the market. Our results suggest that trading volume does seem to have some predictive power for high volume firms and in certain industries of the Australian market. However, for smaller firms, trading volume does not seem to have the same predictive power to explain stock returns in Australia.     

Market Efficiency Anomalies in Korea: Mispricing vs. Omitted Risk Factors

Using a sample of Korean firms, this paper examines whether abnormal returns to various trading strategies based on publicly available information are consistent with mispricing (market inefficiency) or with the fundamental variables proxying for omitted risk factors. Results of various tests indicate that significant abnormal trading profits observed from DeBondt and Thaler';s (1985) contrarian strategy and Ou and Penman';s (1989) and Holthausen and Larcker';s (1992) Pr-strategies are likely to be a result of market mispricing, while those from trading strategies based on firm size, earnings-to-price ratios, and book-to-price ratios are likely to be a result of omitted risk factors.     

Earnings announcements,private information,and strategic informed trading

In this paper, we estimate and test a multi-period model of strategic informed trading developed by Foster and Viswanathan [Foster, F.-D., Viswanathan, S., 1996. Strategic trading when agents forecast the forecasts of others, J. Finance 51, 1437–1478]. We employ the GMM using intertemporal patterns of price, trading volume and market depth, leading up to the earnings announcements made by NYSE firms. We find that multiple informed traders with heterogeneous private signals trade prior to the announcements. In addition, by comparing the results from daily and intra-day estimations, we find that the number of informed traders increases while the intensity of liquidity trading decreases, and that the adverse selection problem becomes more pronounced as the announcements approach.