When do informed traders acquire and trade on informational advantage? Evidence from Federal Reserve stress tests

• Author: Robert Loveland,Scott Fung
• Date: 01 October 2020
• Published date: 01 October 2020
• DOI: http://doi.org/10.1002/fut.22149

J Futures Markets. 2020;40:1459–1485. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals LLC

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1459

Received: 2 September 2019

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Accepted: 13 June 2020

DOI: 10.1002/fut.22149

RESEARCH ARTICLE

When do informed traders acquire and trade on

informational advantage? Evidence from Federal

Reserve stress tests

Scott Fung |Robert Loveland

Department of Accounting and Finance,

College of Business and Economics,

California State University‐East Bay,

Hayward, California

Correspondence

Robert Loveland, Department of

Accounting and Finance, College of

Business and Economics, California State

University‐East Bay, 25800 Carlos Bee

Blvd., Hayward, CA 94542.

Email: robert.loveland@csueastbay.edu

Abstract

Using Federal Reserve bank stress test announcements, we examine when

option traders acquire informational advantage and when they exploit it. We

find consistent evidence of informed options trading around announcements.

However, when test results are announced in successive weeks we find high

abnormal option volume, considerably positive abnormal returns and sig-

nificant return predictability in the first week, but not the following week. This

suggests that informed option traders are able to anticipate upcoming news

events and skillfully process public information but it also suggests that trading

on acquired information is conditioned on the level of information asymmetry

in the market.

KEYWORDS

banking, bank stress test, implied volatility, information efficiency, options trading

JEL CLASSIFICATION

G13; G14; G21; G28

1|INTRODUCTION

The presence of informed traders in the options market has been established in the literature on financial markets

largely by demonstrating the stock return predictability of option trading (e.g., Cremers & Weinbaum, 2010; Pan &

Poteshman, 2006).

1

While the extant literature firmly establishes the link between informed option trading and sub-

sequent stock returns, there is less evidence regarding the nature and timing of informed traders' information acqui-

sition efforts and the linkage to subsequent trading activity.

This study seeks to extend the options literature by providing new evidence regarding (i) when informed option

traders acquire information and (ii) when they choose to trade on that information. We employ a novel data set to

examine the patterns of equity option trading around announcements of Federal Reserve supervisory stress test results

for US bank holding companies. An important feature of the stress tests, for our purposes, is the staggered public release

of data in a tight two week window. Data (and test results) released in week one are used by the Federal Reserve as

inputs to additional tests whose results are subsequently released in the following week. This dynamic feature allows us

1

Past studies suggest that return predictability is particularly strong during such events as earnings announcements (Atilgan, 2014; Jin, Livnat, &

Zhang, 2012), corporate takeovers (Cao, Chen, & Griffin, 2005), leveraged buyouts (Acharya & Johnson, 2007), stock splits (Gharghori, Maberly, &

Nguyen, 2017), and among others.

to utilize the initial data release as an innovation to the existing information set and track the impact of the new data on

our option trading measures after their release. In addition, the complex nature of the detailed and sophisticated bank

regulatory data publicly released in the stress test disclosures provides fertile ground for our tests of information

acquisition.

The theoretical literature on informed trading provides us with predictions as to when option traders gain an

informational advantage and when they trade on it. Traders may be able to anticipate upcoming news events, either

through the acquisition of private information or a superior ability to process public information, in which case the

literature suggests traders would optimally trade prior to news announcements (Glosten & Milgrom, 1985; Kim &

Verrecchia, 1991a). However, option traders may gain their information advantage after news announcements due to

their superior ability to process complex information contained in the announcement. In this case, option traders are

more likely to trade on, and following, news release dates (Kandel & Pearson, 1995; Kim & Verrecchia, 1994). Im-

portantly, these two information sources need not be mutually exclusive. Kim and Verrecchia (1997) build a model that

features informed trading when information asymmetry is high, which occurs in their model both before and after a

news event.

Recent empirical studies provide consistent evidence of informed option trading before and after public news

releases and considerable support for both the private information and superior processing ability hypotheses (see, e.g.,

Weinbaum, Fodor, Muravyev, & Cremers, 2020; Gharghori et al., 2017; Hao, 2016; Jin et al., 2012). Our aim in this

paper is not necessarily to disprove one theory for the other, but rather, by applying a new data set to this field we aim

to better understand the patterns of acquisition, and use, of data for informed trading purposes. In this regard, the

hypotheses give us testable predictions to guide our investigation, even if the predictions are open to interpretation.

2

US bank regulatory agencies instituted stress testing after the Financial Crisis in part to help restore confidence in

the US banking system. A critical aspect of that mission was the public disclosure of “unprecedented confidential

supervisory information”(Flannery, Hirtle, & Kovner, 2017, p. 3). Flannery et al. (2017) conclude that Federal Reserve

stress tests encourage the production of private information about both the stress‐tested bank holding companies and

the overall state of the banking industry. Additionally, suggestive evidence of information leakage and systematic

informed trading ahead of Federal Reserve news releases (Bernile, Hu, & Tang, 2016) indicates the potential for more

than one avenue of information acquisition during bank stress tests. Because stress tests involve a great deal of

information disclosure about the health of the bank test subjects, and because a portion of this information is im-

pounded in stock prices prior to the announcement of test results, the announcement of bank stress test results provides

a fertile setting to examine the flow of public versus private information. Moreover, the nature and timing of the Federal

Reserve news releases ‐complex underlying data, iterative public release of data that accumulates investor under-

standing, issued by a credible regulatory agency with supervisory authority ‐also allows for the generalization of our

findings to other industries or settings subject to regulatory oversight. By relaxing some constraints around information

quality, our findings are relevant for a broad range of information settings, such as corporate news releases and

intraquarter updates.

Importantly, the sequential nature of the Federal Reserve news releases also allows us to adapt prior research to

provide more detailed predictions regarding when informed option traders may choose to exploit their informational

advantage. Theoretical work, such as Holthausen and Verrecchia (1988) and Kim and Verrecchia (1991b), models price

reactions to new information as a function of the informativeness of previously released related information. Em-

pirically, these models predict that as the first information release becomes increasingly (decreasingly) informative, the

level of returns to the first release increases (decreases) while the level of returns to the second release decreases

(increases). If greater information asymmetry creates more profitable trading opportunities for informed traders

(Engelberg, Reed, & Ringgenberg, 2012), then the relative level of returns around each test result release should provide

us with information about the level of information asymmetry present in the market and thus explain the timing of the

activity of informed traders.

Our results can be summarized as follows. To start, we first establish the presence of informed traders in the options

market around the announcement of stress test results by running a battery of tests. We find that abnormal option

volume, volatility spread, and volatility skew are significantly greater on both announcement day and the preceding

10 days, on average, for banks that receive an objection versus banks that do not. We next find that options trades

2

For example, an alternative interpretation of the timing of informed trading may be that uninformed investors neglect others' private information

(Eyster, Rabin, & Vayanos, 2019) or trade less due to bounded rationality (Pouget, 2007). As such, there would be opportunity for informed traders to

take advantage of their informational endowments even after an information release. We thank an anonymous reviewer for this suggestion.

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