Is options trading informed? Evidence from credit rating change announcements

AuthorJun Zhang
Date01 September 2019
DOIhttp://doi.org/10.1002/fut.22022
Published date01 September 2019
J Futures Markets. 2019;39:10851106. wileyonlinelibrary.com/journal/fut © 2019 Wiley Periodicals, Inc.
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1085
Received: 26 December 2018
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Revised: 9 May 2019
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Accepted: 9 May 2019
DOI: 10.1002/fut.22022
RESEARCH ARTICLE
Is options trading informed? Evidence from credit rating
change announcements
Jun Zhang
Department of Finance, Spears School of
Business, Oklahoma State University,
Stillwater, Oklahoma
Correspondence
Jun Zhang, Department of Finance,
Spears School of Business, Oklahoma
State University, Stillwater, OK 74078.
Email: jun.zhang@okstate.edu
Abstract
Using a sample of proactive credit rating changes, this study examines the
information content of options trading before news events. Preevent informed
options trading predicts cumulative abnormal returns around credit rating
change announcements. The predictability of options trading is more
pronounced before announcements of more severe and surprising rating
changes. Moreover, the information content of preevent options trading is
greater when the preevent underlying stock market is less informational, when
the options market is more liquid, and in the postregulation fair disclosure
period. Overall results are consistent with informed options trading before
credit rating change announcements.
KEYWORDS
credit rating change, informed trading, options trading
1
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INTRODUCTION
Informed trading has long attracted much academic and regulatory attention, and recent research has documented
informed options trading before corporate news events.
1
Due to higher leverage and lower costs of options trading
(Back, 1993; H. Cao, 1999; Easley, OHara, & Srinivas, 1998), informed traders may choose to trade options rather than
stocks before informational events to capitalize on their private information. As a result, options trading conveys
information of upcoming news events ahead of stock market reactions, option prices lead stock prices, and the options
market has a significant contribution to price discovery (Chakravarty, Gulen, & Mayhew, 2004). Informed options
trading, measured by, for example, abnormal implied volatility spread and skew, has been shown to predict abnormal
stock returns around corporate news events (Chan et al., 2015; Hao, 2016; Jin et al., 2012).
However, there is still debate in literature on the information content of options trading. Some studies argue that
options trading is not informed and does not convey information of 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, examining information content of options trading and identifying the source of information are
sometimes complicated in cases of wellanticipated or scheduled corporate events, for which it is difficult to distinguish
information advantage of privately informed traders from some sophisticated traderssuperior capability of processing
publicly available information or merely reactions to market anticipation and rumor. Therefore, the choice of news
events with a clean setup is very important for studying information content of options trading before corporate news
events.
1
See, for example, Hayunga and Lung (2014) (analyst recommendations), Jayaraman, Frye, and Sabherwal (2001), C. Cao, Chen, and Griffin (2005), Spyrou, Tsekrekos, and Siougle (2011), Augustin,
Brenner, and Subrahmanyam (2015), Chan, Ge, and Lin (2015) (merger and acquisitionannouncements), Jin, Livnat, and Zhang (2012) (earnings announcements), and Hao (2016) (share repurchase
announcements).
This study contributes to the line of literature by examining the information content of options trading before
announcements of proactive bond credit rating changes. Credit rating agencies (CRAs), such as Moodys, Standard &
Poors, and Fitch, assess the creditworthiness of firms and their debt obligations and assign ratings accordingly.
Announcements of bond credit rating changes convey very important information about firm fundamentals and have
strong implications on future corporate financing and investment policies. The stock market reacts to the credit rating
change announcements, especially the downgrade announcements.
Many rating agency announcements are triggered by other firmspecific news events or preceded by credit watch
placement, which may contaminate the information content of both rating change announcements and options trading
before them. To eliminate the confounding effect and isolate the information content of options trading before rating
change announcements, I exclude contaminated rating changes that are preceded by other corporate events or credit
watch to create a sample of proactive credit rating changes that are likely to surprise the market at their
announcements.
2
Restricting the sample to proactive rating changes makes sure that the rating change announcements
in the final sample contain incremental information and the preevent informed options trading is due to the rating
change announcements only, which are very important for interpretation of the results in the paper.
Credit rating change announcements are different from many other corporate news events in several ways. First,
credit rating change announcements are not scheduled. Traders may anticipate potential changes in credit ratings based
on publicly released firm fundamental information, but it is unlikely for them to predict the exact dates of
announcements and time their trading with actual announcement dates. Those traders whose options trading
consistently predicts future stock price movements around credit rating change announcements most likely have
private information about the forthcoming announcements. Second, credit rating change announcements are not made
by firms, but instead, by CRAs. Informed option traders trading before credit rating change announcements must have
acquired their private information from rating agencies, regarding the direction, level, and timing of credit rating
changes. This information acquisition channel is different from the common information tipping or leakage from
corporate inside. In addition, credit rating changes have lots of variation in terms of directions (i.e., upgrading and
downgrading) and magnitude (e.g., singlenotch changes vs. multinotch changes, withinclass change vs. across class
changes), and thus, allow detailed examinations of the information content of options trading before different types of
credit rating changes. Therefore, credit rating change announcements provide a clean and desirable setup to examine
information content of options trading before news events.
Following recent literature, 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 credit
rating change announcement returns. By their construction of the two measures,
3
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. So IV spread is constructed to
capture broad views of options traders, while IV skew is designed to capture negative views of options traders.
Examining the two informed options trading measures helps to identify the information content of different types of
credit rating changes.
I find that options trading before credit rating change announcements is informational and predicts the future stock
returns. Of the two informed options trading measures, abnormal IV spread is significantly and positively related to
cumulative abnormal credit rating change announcement returns, and abnormal IV skew is significantly and negatively
related to cumulative abnormal announcement returns. The information content of options trading is greater before
announcements of certain types of rating changes deemed more informational or severe, such as rating downgrades,
rating changes with negative stock market reactions, multinotch rating changes, and rating changes across broad letter
classes. The information content of options trading is also greater when the options market is more liquid relative to the
underlying stock market, because the options market attracts more informed traders when it is more liquid. Moreover, I
find that the information content of options trading is reduced when the stock market has already incorporated some
information about the rating changes before announcements.
I also explore regulation fair disclosure (RegFD) to examine the dependence of information content of options
trading on the information content of credit rating changes. RegFD, implemented on October 23, 2000, prohibits US
public companies from making selective, nonpublic disclosures to favored investment professionals. But RegFD permits
disclosure of nonpublic information to CRAs. As a result, credit agencies have access to confidential firm information
2
See Section 3 for details on sample filtering.
3
The construction of the two informed options trading measures will be described in Section 3.
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