How Informed Investors Take Advantage of Negative Information in Options and Stock Markets

• DOI: http://doi.org/10.1002/fut.21651
• Date: 01 June 2014
• Published date: 01 June 2014

HOW INFORMED INVESTORS TAKE ADVANTAGE

OF NEGATIVE INFORMATION IN OPTIONS

AND STOCK MARKETS

JANGKOO KANG and HYOUNG‐JIN PARK*

We examine whether andhow investors establish positions in options when they have negative

informationin the U.S. markets from August 2004to January 2009. Our empiricalresults show

that options seemto be actively and effectively used for the exploitationof negative information.

General tradingvolumes and bid–ask spreads of optionsremarkably increase like thoseof stocks

as the short sellersincrease their selling pressure.Notably, we find that the differencebetween a

stock’s tradedprice and its implied pricefrom the options market reachesits peak about 2 weeks

before the short sale trading activity reaches its peak. We also observe that synthetic short

positions measured by this difference are preferred over OTM put positions by investors with

negative information. Finally, economically significant returns based on a strategy using the

difference in the traded and implied stock prices as a trading signal support our evidence.

Moreover,these profits confirmthe findings of the previous researchwhich argue that options are

shelters for informedinvestors. © 2014 Wiley Periodicals,Inc. Jrl Fut Mark 34:516–547, 2014

1. INTRODUCTION

Whether limits of arbitrage truly impede information dissemination has been examined in

numerous studiessince addressed first by Shleifer and Vishny (1997). In particular,restrictions

on short sales, a representative example of limits of arbitrage, are regarded as the culprit that

makes it harder for investorsto trade when they have negative information than when they have

positive information.On the other hand, starting with Black (1975), for a long time it hasbeen

suggested that options are venues where investors can detour these restrictions in order to

exploit their negative information. Even though several decadeshave passed from the time the

usage of options for avoidingrestrictions in the stock market was firstly discussed, the question

whether investors with negative information first choose options to trade before stocks is still

not resolved. Few studies have investigated changes in prices and trading activities directly in

both the stock and options markets when negative information appears in the markets.

This study explores the trading strategies and habitats of informed investors, especially of

informed investors with negative information, by examining the existence and the extent of

synthetic short trades in the options market. To do this, firstly we set up an empirical

Jangkoo Kang is a Professor in Korea Advanced Institute of Science & Technology, Dongdaemun‐Gu, Seoul,

Korea. Hyoung‐Jin Park is an Assistant Professor in Seoul Women’s University, Nowon‐Gu, Seoul, Korea.

JEL Classfication: G11, G14

This work was supported by a special research grant from Seoul Women’s University (2014).

*Correspondence author, Seoul Women’s University, 621 Hwarangro, Nowon‐Gu, Seoul 139‐774, Korea. Tel:

þ82‐2‐970‐5518, e‐mail: narita@swu.ac.kr

Received November 2013; Accepted December 2013

The Journal of Futures Markets, Vol. 34, No. 6, 516–547 (2014)

© 2014 Wiley Periodicals, Inc.

Published online 26 January 2014 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21651

circumstance where option trades with negative information can be easily observed. It is rational

to presume that negative information appears in the markets when short sales are significantly

increasing because there should be an incentive for investors to short sell a stock so the return

from the short sale is large enough to cover its costs. Previous literature supports this

presumption with empirical results in which stock returns decrease significantly for a few days

after short sales suspiciously increase (Asquith & Meulbroek, 1995; Christophe, Ferri, &

Angel, 2004; Desai, Ramesh, Thiagarajan, & Balachandram, 2002). Therefore, we proxy the time

of release of negative information into the markets with the time of an abnormal increase in short

sale trades in the stock market. Then, we examine whether options are used like short selling by

looking into prices and trading activities in the options market. Secondly, we investigate the

sequence between the informed trades in the options market and short sales in the stock market

in order to confirm more clearly that options, not stocks, are placed first on the table by investors

with negative information. Thirdly, we examine whether the appearance of negative information

can be detected by merely measuring the extent of synthetic short sale trades in the options

market without considering the stock market. Finally, we test the economic significance of

synthetic short sale trades and compare it with the productivity of short sales in the stock market.

If investors want to exploit their negative information in the options market, they can buy

OTM puts or establish synthetic short positions. As argued in Xing, Zhang, and Zhao (2010),

relatively cheap OTM puts can attract more informed investors with negative information

than other options. In their results, the difference in the implied volatilities of OTM puts and

ATM calls can foreshadow a future stock return decrease—the greater the difference, the

greater the decrease. However, if investors want to optimize and maximize their profit from

their negative information, they will write calls and buy puts simultaneously, in other words,

establish synthetic short positions. Although it sounds natural for investors with negative

information to establish synthetic short positions, unfortunately, not many studies have

examined the extent of synthetic short positions in the options market. This is because, unlike

short sale trading volumes which are reported regularly, it is nearly impossible to calculate how

many synthetic short positions are established in the options market. Therefore, it is

questionable which strategy investors will take for exploiting their negative information: short

sales, OTM puts, or synthetic short positions.

We hypothesize that the options market is more attractive to informed investors with

negative information than the stock market because of the following three reasons. First of all,

the fee for establishing synthetic short positions is less than directly short selling the stocks.

The fee for short selling is composed of two costs, the opportunity cost of maintaining a margin

and the cost of paying the lenders of the stock. Because the loss incurred by short sellers in the

stock market is potentially unlimited, they are required to maintain a certain margin balance

as collateral. Besides the opportunity cost of the margin, short sellers should also pay a

commission to the lenders of the stock, and the higher the risk is, the greater the commission

is. Next, the number of shares which short sellers can borrow in the stock market is limited

because all stock owners do not voluntarily lend their shares. Contrarily, options can be traded

without a limit on the number of positions. Lastly, and most noteworthily, traders with

negative information might be afraid that other traders will suspect they have negative

information if they engage in short selling because the volume of short sales is reported on a

regular basis by the exchange to the public. Therefore, whether the short seller’s information

is true or not, the market treats high short sale trading volume as suspicious. Thus, informed

investors may want to trade in the options market in order to disguise their trading intention.

Based on options’advantages in the above three aspects, we examine whether informed

investors with negative information migrate to the options market.

We examine U.S. stocks and their individual options from August 2004 to January 2009

with a unique data set for short sale trades provided by Data Explorers. The data for short

How Informed Investors Take Advantage 517

selling contain the commission to lenders, the total short trading volume, and the utilization

level, which is the percentage of shares actually borrowed from among the total shares offered

by lenders. With this data, we firstly calculate weekly short sale trading volumes in the stock

market. Then, we use these weekly volumes to assess when negative information appears

publicly in the stock market. Specifically, the week having the highest short sale trading

volume among the 10 previous weekly volumes is defined as the time when the information is

revealed to the public. To investigate whether informed investors utilize options and whether

they trade options before stocks, instead of calculating the number of synthetic short positions

in the options market, we estimate the stock price ratio suggested by Ofek, Richardson, and

Whitelaw (2004). Contrary to short sale trading volume in the stock market, it is nearly

impossible to calculate the number of synthetic short sales positions because we cannot trace

the trading history of individual investors in the options market. Hence, we adopt the stock

price ratio as a proxy for the extent of synthetic short positions. This ratio shows the difference

between the actual traded stock price and the implied stock price from options. We assume

that the more the synthetic positions in the options market are established by informed

investors with negative information, the greater the difference between the two stock prices is.

In our empirical results, consistent with the existing literature, stock prices decrease

sharply after the peak of short sale trading volumes in the stock market. During the previous

10 weeks before the short sale trading volume reaches its peak, the short sale fee and the short

sale trading volume gradually increase together during the first 8 weeks and then they both rise

rapidly for the last 2 weeks. After the peak week, the fee stays at the elevated level, but the

amount of short sales begins to decrease. The cumulative stock return shows no statistically

significant variation from zero for the initial 10 weeks, but decreases by 6% during the 10

weeks after the peak week. In the options market, for the same period, we also observe changes

in the stock price ratio. However, the changes in the options market start and end at different

times than the stock market. Most of the changes in the stock price ratio occur during the

2‐week period that begins 4 weeks prior to the peak week. From the first week before the peak

week, the ratio begins to decrease. Even though the level of the stock price ratio becomes

greater as the option’s maturity gets longer, the increase in the stock price ratio before the

peak weak is detected regardless of the option’s maturity. In addition, the general trading

volume of the options market is observed to increase in tandem with the stock price ratio.

However, OTM puts do not seem to be popularly used by investors with negative info rmation

so the volatility skew of the difference between the implied volatilities of these options does not

show strong predictability about future stock returns. Next, we ascertain whether the

appearance of negative information can be detected by solely estimating the extent of the stock

price ratio in the options market without considering the stock market. Finally, we examine

trading performances of portfolios constructed according to the stock price ratio. The trading

strategy of selling stocks with high stock price ratios yields about a 15% return per year.

Furthermore, establishing synthetic short positions generates an even greater 20% yearly

return and this profit is still significant after considering transaction costs. Therefore, we

conclude that informed investors establish synthetic short sale positions in the options market

first and then engage in short sales in the stock market.

Our results provide evidence that the stock and options markets are efficiently linked by

informed investors’trading activity. The previous price discovery literature that examines

informed habitats (Amin & Lee, 1997; Boehmer & Kelly, 2009; Chakravarty, Gluen, &

Mayhew, 2004; Chordia, Roll, & Subrahmanyam; 2005; Easley, O’Hara, & Srinivas, 1998;

Hasbrouck, 1993; Pan & Poteshman, 2006; Schlag & Stoll, 2005) argues that informed

investors exploit their information through the options market. However, some studies

(Cochrane, 2002; Ofek, Richardson, & Whitelaw, 2004) argue that there is market separation

between the stock and options markets because of the different groups of participants having

518 Kang and Park