INFORMED OPTIONS TRADING BEFORE AUDITOR CHANGE ANNOUNCEMENTS

• DOI: http://doi.org/10.1111/jfir.12147
• Published date: 01 June 2018
• Date: 01 June 2018
• Author: Jun Zhang

INFORMED OPTIONS TRADING BEFORE AUDITOR CHANGE

ANNOUNCEMENTS

Jun Zhang

Oklahoma State University

Abstract

In this article I examine the information content of options trading before auditor change

announcements. Preannouncement abnormal implied volatility (IV) skew is negatively

and significantly related to cumulative abnormal returns around auditor change

announcements. The predictive power of abnormal IV skew is stronger for announce-

ments of negative auditor changes and when the options market is more liquid, and is

weaker when information has already been incorporated in the stock market. The results

are robust to a placebo test and an alternative measure of informed options trading.

Overall results suggest that informed options trading predicts auditor change

announcement returns.

JEL Classification: G14, G38

I. Introduction

Informed traders can choose to trade on their private information in the stock market or

the options market before news and events, and may prefer to trade options rather than

stocks due to higher leverage, lower trading costs, and more efficient trading of the

options market (Back 1993; Easley, O’Hara, and Srinivas 1998; Cao 1999). Traders in

the options market convey information about the stock market and option prices lead

stock prices, and the options market makes a significant contribution to price discovery

(Chakravarty, Gulen, and Mayhew 2004). The literature has shown that informed traders

trade in option markets before corporate news events, such as analyst recommendations

(Hayunga and Lung 2014), merger and acquisition (M&A) announcements (Jayaraman,

Frye, and Sabherwal 2001; Cao, Chen, and Griffin 2005; Augustin, Brenner, and

Subrahmanyam 2015; Chan, Ge, and Lin 2015), earnings announcements (Jin, Livnat,

and Zhang 2012), and share repurchase announcements (Hao 2016). These findings

suggest that option traders have an information advantage over equity traders before

informational events. Informed options trading, measured by, for example, implied

volatility (IV) spread and IV skew, has been shown to have predictive power for

abnormal returns around informational events (Jin, Livnat, and Zhang 2012; Chan, Ge,

and Lin 2015; Hao 2016).

However, there exists debate on the predictability of options trading. Some

studies indicate that options trading does not convey information about future stock

prices. For example, Chan, Chung, and Fong (2002) find that after controlling for stock

trading volume, options trading volume has no incremental predictive power. In addition,

investigating the predictive ability of options trading is sometimes complicated in cases

The Journal of Financial Research Vol. XLI, No. 2 Pages 213–236 Summer 2018

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© 2018 The Southern Finance Association and the Southwestern Finance Association

of well-anticipated or scheduled corporate events, for which it is difficult to distinguish

the information advantage of informed options traders from market anticipation or

rumor.

This study contributes to the literature by examining the informativeness of

options trading before auditor change announcements. Auditor changes are important

corporate events that require public disclosure in Form 8-K.

1

The U.S. Securities and

Exchange Commission (SEC) requires that Form 8-K not only report a change in auditor,

but also disclose the reason for the change. A firm may realign with a larger auditor (i.e.,

upgrade) or a smaller auditor (i.e., downgrade), or change to an audit firm of similar level

(i.e., lateral change). In addition, auditor changes may involve the resignation of an

auditor or a disagreement between management and the existing auditor. Different from

scheduled corporate events such as earnings announcements and analyst recommen-

dations, auditor changes are not prescheduled, and unlike M&As, auditor changes are not

major corporate events that attract significant market attention and involve the

complications of market rumor or anticipation. Therefore, auditor change announce-

ments provide a cleaner setup to examine information content and predictability of

options trading before informational events.

Studies on auditor change announc ements have focused on stock marke t

reaction around auditor change anno uncements, and there is mixed evidenc e on the

informativeness of auditor chang e announcements. Many studies have docu mented

significant, and generally ne gative, stock market reaction on and after auditor change

announcements. For example , Fried and Schiff (1981) find a negat ive market reaction

around the time of certified publ ic accountant (CPA) switch es. Wells and Loudder

(1997), Shu (2000), and Griffin and Lont (2010) find that inv estors react most

negatively to auditor resign ations. However, Klock (19 94) shows that the market

ignores auditor switches and t here is no market reaction to audi tor changes, and

Nichols and Smith (1983) find no sign ificant abnormal stock retur ns around auditor

changes. I investigate the informat ion content of options trading before aud itor change

announcements. If auditor ch ange announcements are inf ormative, informed trader s

may trade on the information, and they may choose to trade in the options market

because of its lower trading cos t and higher leverage. Evidence of informed option s

trading before auditor change announcements suggests that auditor change announce-

ments are informative.

Auditor changes can be auditor upgrades, auditor downgrades, lateral changes,

auditor changes resulting from auditor resignations, and auditor changes resulting from

auditor and company disagreement. Auditor downgrades and auditor changes due to

auditor resignations or auditor and company disagreement may be regarded by the

1

Sections 13 and 15 of the Securities Act of 1934 require firms to submit Form 8-K to the SEC for a series of

corporate events including auditor changes. Form 8-K must be filed within 5 business days after a new auditor is

hired or the former auditor is dismissed, resigns, or declines to stand for reelection. On average, firms in my sample

file Form 8-K 4.33 days after the decision to change auditors has been made. This is consistent with Carter and Soo

(1999), who find that firms, on average, file Form 8-K 4.93 days after the event. I use the dismiss date contained in

the Audit Analytics data as the event date. By checking Forms 8-K, I confirm that the dismiss date in the Audit

Analytics data is the actual event date or decision date, that is, the date when the board makes decision to change

auditor and when the change is effective.

214 The Journal of Financial Research