Tipping and Option Trading

• DOI: http://doi.org/10.1111/fima.12052
• Author: Pisun Xu,Pei Peter Lung
• Date: 01 September 2014
• Published date: 01 September 2014

Tipping and Option Trading

Pei Peter Lung and Pisun Xu∗

This study examines options’ market behavior before analysts’ initiations. We find abnormal

trading activity in the options market several days prior to the release of analysts’ initiations.

Informed traders recognizethe content and timing of the initial recommendations. We determine

that informed trading is attributed to information leakage rather than savvy investors’ stock-

picking ability. We also find a significant information transmission from the options market to the

underlying equity market aroundthe event. Our results are consistent with the tipping hypothesis

and confirm the informational role of equity options.

The informational role of derivatives has emerged as an important economic function.1A

growing body of literature has studied the effectiveness of the options market for information

and price discovery (Donders and Vorst, 1996; Amin and Lee, 1997; Donders, Kouwenberg, and

Vorst, 2000; Isakov and Perignon, 2001; Roll, Schwartz, and Subrahmanyam, 2010; Hayungaand

Lung, 2014). This paper contributes to this body of knowledge by investigatinginfor med trading

in the options market around the release of analysts’ initiations.

The recent literature provides evidence concerning information leakage prior to financial

analysts’ recommendations. Irvine, Lipson, and Pucket (2007) develop a tipping hypothesis

and find supporting evidence. They argue that financial analysts have incentives to prerelease

their research to select investors as the cost of research can be recovered from commissions

on the trading activity of brokerage clients who benefit from the research. They find elevated

institutional buying in the stock market prior to public distribution of initial recommendations.

Markov, Muslu, and Subasi (2011) further confir m the tipping hypothesis by documenting new

evidence regarding interactions betweeninfor med investorsand analysts prior to initiations. They

find that analyst-hosted conferences govern private information exchanges among companies,

analysts, and select investors prior to analysts’ initiations.

This emerging body of literature regarding informed trading prior to analysts’ initiations has

focused mainly on the stock market. It is intriguing to examine whether informed investors

also use options to exploit their information advantage. Previous literature indicates that the

options market offers significant advantages to informed traders as opposed to the stock market.

A few studies confirm that in the absence of market completeness, financial leverage, short

sale constraints, and built-in downside protection may induce informed traders to trade options

instead of underlying assets (Black, 1975; Diamond and Verrecchia, 1987; Back, 1992; Mayhew,

Sarin, and Shastri, 1995). Easley, O’Hara, and Srinivas (1998) argue that the options market is

more attractive as informed traders can hide themselves better among uninformed traders due

to the availability of multiple options contracts for each stock. Cao (1999) argues that agents

with information about future contingencies should be able to trade more effectively on their

information in the presence of options. Hu (2012) finds that permanent price infor mation in stock

∗PeiPeter Lung is the Denver Clearing House Endowed Chair Professorof Finance at the University of Denver in Denver,

CO. Pisun Xu is an Associate Professorof Finance at the University of Denver in Denver, CO.

1See the statistical release of Bank for International Settlements – “OTC DerivativesStatistics at End–June 2013,” which

is available at http://www.bis.org/publ/otc_hy1311.pdf.

Financial Management •Fall 2014 •pages 671 - 701

672 Financial Management rFall 2014

order flow is primarily induced by option transactions, suggesting that the options market is the

preferred venue for informed trading.

As one of the important unscheduled information events, analysts’ initiations represent a

unique and valuable setting to study informed trading. Irvine et al. (2007) point out that the

contents of an analyst’s report will typically be known internally several days prior to any public

announcements. Initiation-related information is given first to select investors and subsequently

released to the general public. Such a two-tiered process of releasing initial recommendations

ascertains empirically whether and when private information is used in trading.

If analysts leak the information to select investors, the informed investors should have specific

knowledge of the timing and content of the analysts’ reports. The information advantage can be

substantial and the potential reward, ifcoupled with the leverage of options, can be considerable.

The value of such information should drive the heightened informed trading ahead of the event.

Thus, analysts’ initiations are ideal for studying informed trading in the options market.

Our sample includes 1,734 Buy Initiations and 283 Sell Initiations from 2009 to 2011. We

first examine option trading activity around analysts’ initiations. Using option-implied prices and

call-to-put trading volume, we find that option investors trade in the same direction as indicated

in the forthcoming analysts’ initiations. The options market exhibits abnormal trading behavior

beginning seven days prior to the public release of initiations, which is five days earlier than the

stock market during our sample period.

We also examine how information is transmitted between the stock and options markets prior

to analysts’ initiations based on a two-stage specification as in Acharya and Johnson (2007). Our

findings indicate a significant infor mation transmission from the options market to the underlying

equity market around the financial analysts’ initiations. Conditional upon the initiation events,

we find a 43% transmission of information from options market innovations to future stock

market returns for initial sell recommendations and 37% for initial buy recommendations. The

information transmission suggests that the options market leads the stock market in response to

analysts’ initiations. These results suggest that informed investors prefer options to stocks when

trading private information (Chakravarty, Gulen, and Mayhew, 2004; Pan and Poteshman, 2006;

Bali and Hovakimian, 2009; Xing, Zhang, and Zhao, 2010).

In addition, we analyze whetherthe infor med trading in the options marketis attrib uted to savvy

investors’ stock selection ability or analysts’ information leakage. On the one hand,the infor med

trading could be attributed to savvy investors’ predictability as both savvyinvestors and financial

analysts may use similar information to assess the value of a stock. Alternatively, analysts could

leak their initial recommendations to a select investorunintentionally or purposely. If the abnormal

trading activity in the options market correctly reveals the content and the timing of initiations,

informed trading should be attributed to information leakage. Based on the analysts’ target price,

along with the timing of their initial recommendations, we find that the options market behaves

abnormally prior to analysts’ initiations and the magnitude of abnormal trading activity is closely

related to the target price. Thus, our findings indicate that information leakage, rather than stock

picking ability,attrib utes to the abnormal trading behaviorin the options market prior to f inancial

analysts’ initiations.

Furthermore, our simulation results suggest that informed investors can make substantial profits

from trading in the options market. When informed investors purchase call options seven days

before an upcoming buy initiation and close the position when an initial buy recommendation is

publicly released, they can make an average return of 4.47% in seven days, which is more than

four times the return in the stock market. Similarly, informed investors can generate a return of

5.09% in seven days by buying put options before an initial sell recommendation.