Informed options trading prior to insider trades

• Published date: 01 August 2021
• Author: (Grace) Qing Hao,Keming Li
• Date: 01 August 2021
• DOI: http://doi.org/10.1111/fire.12259

DOI: 10.1111/fire.12259

PAPER SUBMITTED FOR REVIEW

Informed options trading prior to insider trades

(Grace) Qing Hao1Kem ing Li2

1Department of Finance and Real Estate,

College of Business, University of Texasat

Arlington, Arlington, Texas

2Department of Accounting, Computing and

Finance, College of Business, TexasA&M

University-San Antonio, San Antonio, Texas

Correspondence

(Grace)Qing Hao, Department of Finance and

RealEstate, College of Business, University of

TexasatArlington, Arlington, TX 76019.

Email:Qhao@uta.edu

Abstract

We find abnormal volatility spreads in the options mar-

ket immediately before corporate insider stock trades, sug-

gesting informed options trading prior to insider trades.

The informed options trading is more pronounced for large

insider trades, firms in more corrupt areas, and insider pur-

chases in firms with high information asymmetry. Further-

more, the abnormal volatility spreads are positively associ-

ated with the post-trade abnormal returns. In the aftermath

of the Securities and Exchange Commission’s squawk box

cases, informed options trading before insider trades mostly

disappeared except for a group of insider stock sales related

to insider derivatives transactions such as employee stock

options exercises.

KEYWORDS

information leakage, options market, order exposure risk, insider

trades, volatility spread

JEL CLASSIFICATION

G10, G14

There’s no better tip-off to the probable success of a stock than that people in the company are putting

their own money into it. Insider selling usually means nothing, and it’s silly to react to it. There are many

reasons that officers might sell. They mayneed the money to pay their children’s tuition or to buy a new

house or to satisfy a debt. They may have decided to diversify into other stocks. But there’s only one

reason that insiders buy: They think the stock price is undervalued and will eventuallygo up.

—Peter Lynchand John Rothchild (1989), One Up on Wall Street

Financial Review. 2021;56:459–480. wileyonlinelibrary.com/journal/fire ©2021 The Eastern Finance Association 459

460 HAO ANDLI

1INTRODUCTION

Corporate insider trades predict future stock returns, which providesan incentive for traders to follow or even front-

run insider trades. Khan and Lu (2013) find evidence that short sellers, facilitated by leaked information, front-run

insider sales. They discuss how the information about an upcoming insider trade can be intercepted in the course of

trade execution.In particular, each brokerage firm has its squawk box system, which is an internal intercom system to

broadcast information within the institution, including information about certain block trades.However, some brokers

allowed outside traders to listen to their internal squawk boxes about confidential order flow,making it possible for

the traders to trade ahead of the orders at better prices. The Securities and ExchangeCommission (SEC) has cracked

down on the squawk boxscheme, starting with its first press release on August 15, 2005 (e.g., SEC, 2005,2006,2009).

Given the evidence in numerous studies that insider purchases are more informative about future stock returns

than insider sales (e.g.,Givoly & Palmon, 1985; Lakonishok & Lee, 2001), informed traders should have a greater incen-

tive to trade ahead of insider purchases than insider sales. However,we are not aware of any study on informed trad-

ing prior to insider purchases. In this study,we examine daily options trading prior to both insider purchases and sales.

Given that the exactdates of insider trades are not publicly known beforehand, the options market is particularly use-

ful for examiningsuch time-sensitive trading because, unlike stocks, options have an expiration date. We try to answer

the following questions: Is there informed trading in the options marketprior to corporate insider stock trades? If yes,

is there a reduction in the informed options trading prior to insider trades in the aftermath of the SEC’s squawk box

cases?

Our main measure of informed trading in the options market is the implied volatility spread, which is the differ-

ence in the implied volatility between pairs of call and put options on the same underlying stock, and with the same

strike price and the same expiration date. Using implied volatility spreads to measure deviations from put-call par-

ity, Cremers and Weinbaum (2010) find that volatility spreads reflect the trading activity of informed investors in

that options prices deviate from put-call parity in the direction of the informed investors’ private information. Link-

ing volatility spreads to information and information disclosure events, Jin, Livnat, and Zhang (2012) confirm that the

predictive ability of volatility spreads is due to options traders’information advantage.

Using a sample of open market stock purchases and sales by corporateinsiders during the period 1996−2012, we

find evidence of informed trading in the options marketprior to both insider purchases and sales. Based on regression

results, the average volatility spread decreases by0.08−0.09% immediately prior to chief executive officers’ (CEOs’)

sales, which is 8−9% of the sample mean during the benchmark period for CEOs’ sales, representing significant down-

ward price pressure in the options market. The averagevolatility spread increases by 0.39−0.45% immediately prior

to CEOs’ purchases, which is 47−54% of the sample mean during the benchmark period for CEOs’ purchases, reflect-

ing even greater upward price pressure in the options market. Our findings are robust to both randomization tests

and placebo tests. The evidence is more pronounced for large insider trades, firms in more corrupt areas, and insider

purchases in firms with high information asymmetry.

To examinewhether there is a reduction in the informed options trading prior to insider trades in the aftermath

of the SEC’s squawk box cases, we compare the pre- and post-SEC crackdown periods. We find informed options

trading prior to insider purchases during the pre-crackdown period but not the post-crackdown period, consistent

with the deterrence effect of the SEC enforcement actions. However,we find options trading prior to insider sales to

be informed in both the pre- and post-crackdown periods. Some insiders sell the stocks they obtained through their

derivatives transactions, such as exercisingthe employee call options granted by their companies. After removing the

derivatives-related insider sales from the sample, we find that the informed options trading prior to insider sales dis-

appeared in the post-crackdown period. However,we do not find any reduction in the informed options trading for

derivatives-related insider sales. We discuss possible explanations.

Furthermore, we find that the abnormal volatility spread is positively associated with the post-trade abnormal

stock returns. If we buy call options on the insider purchase date and sell the same call options later, the returns can

remain positive after considering transaction costs. However, the returns net of transaction costs from buying put