Informed Options Trading Prior to Dividend Change Announcements

• Published date: 01 March 2018
• Author: Jun Zhang
• DOI: http://doi.org/10.1111/fima.12187
• Date: 01 March 2018

Informed Options Trading Prior to

Dividend Change Announcements

Jun Zhang∗

This paper investigates the information content of options trading prior to dividend change an-

nouncements. I find a positive (negative) relation between pre-announcement abnormal implied

volatility (IV) spread (abnormal IV skew) and cumulative abnormal stock returns around divi-

dend change announcements. The predictive power of informed options trading is stronger for

announcements of dividend reduction and when the options market is more liquid relative to the

stock market and weakerwhen information has already been incorporated in the stock market. The

predictability of informed options trading is robust to a placebo test and alternative measures of

informed options trading. Overallresults suggest that informed options trading predicts dividend

change announcement returns.

Informed traders tend to trade in certain markets based on their private information prior to news

and events and prefer to trade options rather than stocks due to higher leverage (or lower trading

costs) and more efficient trading of the options market (Back, 1993; Cao, 1999; Easley, O’Hara,

and Srinivas, 1998). Trades in the options market convey information about the stock market and

option prices lead stock prices in general. Bali and Hovakimian (2009) find a significant relation

between option-implied volatility spreads and expected stock returns, and the results indicate

significant information flow from individual equity options to individual stocks. Cremers and

Weinbaum (2010) also show significant stock return predictability of implied volatility spread.

Prior empirical studies also provide evidence that informed traders trade in options markets

before corporate news events, such as analyst recommendations (Hayunga and Lung, 2014),

merger and acquisition announcements (Augustin, Brenner, and Subrahmanyam, 2015; Cao,

Chen, and Griffin, 2005; Chan, Ge, and Lin, 2015; Jayaraman, Frye, and Sabherwal, 2001),

earnings announcements (Jin, Livnat, and Zhang, 2012), and share repurchase announcements

(Hao, 2016). Findings of these studies suggest that option traders have an information advantage

relative to equity traders before informational events. Informed options trading, measured by, for

example, implied volatility spread and volatility skew, has been shown to have predictive power

for abnormal return around informational events (Chan et al., 2015; Hao, 2016; Jin et al., 2012).

On the other hand, other studies indicate that options trading does not contain privateinfor ma-

tion that predicts future stock prices. Chan, Chung, and Fong (2002) find that after controlling for

stock trading volume, options trading volume has no incremental predictive power for underlying

stock returns. In addition, investigating the predictive ability of options trading is sometimes

complicated in cases of well-anticipated or scheduled corporate events for which it is hard to

distinguish information advantage of informed option traders from market anticipation or rumor.

This study contributes to the line of literature by focusing on the informativeness of options

trading prior to dividend change announcements. When a firm announces a dividend payment,

it is considered as a dividend change only if the announced dividend payment is different from

I am grateful to Bing Han (editor) and an anonymous refereefor helpful comments and suggestions.

∗Jun Zhang is an Assistant Professor in the Department of Financeat the Spears School of Business at Oklahoma State

University in Stillwater,OK.

Financial Management •Spring 2018 •pages 81 – 103

82 Financial Management rSpring 2018

the previous dividend payment. Corporate dividend policies tend to be sticky, and firms do not

often change their dividend payout ratios. When firms do change dividend policies, announce-

ments of dividend change are seldom well anticipated or scheduled. Therefore, compared with

other corporate events that are usually either scheduled (e.g., earnings announcements), or well

anticipated and rumored prior to their announcements (e.g., mergers and acquisitions [M&A]),

dividend change announcements are much less likely to involve complications of market rumor

or anticipation. Therefore, dividend change announcements provide a cleaner setup to examine

information content and predictability of options trading prior to informational events.

Because firms make dividend payment announcements quarterly,a dividend change announce-

ment is specifically defined as a f irm announcing a quarterly dividend payment that is different

from the previous quarter. Following recent literature on predictability of options trading, I

adopt two informed options trading measures—implied volatility (IV) spread as in Cremers and

Weinbaum (2010) and IV skew as in Xing, Zhang, and Zhao (2010)—to test their predictability

on dividend change announcement returns. By construction, a larger IV spread indicates a

higher buying pressure on call options, suggesting possible increase in future stock prices, and

in contrast, a large IV skew indicates a higher demand on put options, suggesting possible drop

in future stock prices.1

I find that the two informed options trading measures have strong predictive power on up-

coming dividend change announcement returns. IV spread is positively related to cumulative

abnormal stock returns around dividend change announcement, and IV skew is negativelyrelated

to cumulative abnormal dividend change announcement return. The predictability of informed

options trading is weaker when the stock market has already incorporated some information

before dividend change announcements and stronger for announcements of dividend reduction

and when options market liquidity is higher. Information incorporated in the stock market prior

to dividend change announcements reduces the informational content of options trading, and the

options market attracts more informed traders when there are negative news such as dividend

reductions and when the options market is more liquid relative to the stock market.

Tofurther conf irm the predictability of informed options trading on dividend change announce-

ment returns, I examine whether the positive (negative) correlation between IV spread (IV skew)

and future stock return exists only on dividend change announcement dates. I create a pseudo-

sample with fake dividend announcement dates and combine it with the sample with real dividend

announcement dates for a placebo test. I find that the positive (negative) correlation between IV

spread (IV skew) and future stock return exists only for real dividend change announcements but

not for the fake announcement dates. The result indicates that the predictive power of informed

options trading is due to informed traders’ private information of upcoming news events. In

addition, the predictability of informed options trading is robust to alternative measures of in-

formed options trading. Overall results support the notion that options trading by informed traders

predicts future stock return around informational events such as dividend change announcements.

This paper contributes to the informed trading literature by relating informed options trading

and abnormal stock return around dividend change announcements. Existing studies on infor-

mation content of options trading mainly focus on major corporate events such as merger and

acquisition and scheduled informational news events such as earnings announcements, and have

not explored options trading before dividend change announcements. Dividend payment is an

important component of payout policies, and informed options trading prior to dividend payment

announcements has not been explored before in the literature. This paper aims to fill that void.

Hao (2016) investigates informed options trading before announcements of share repurchase,

1The construction of the two informed options trading measures will be described in Section II.