Insider Trading When an Underlying Option Is Present

We argue that increased leverage, lower litigation risk, and reduced trading costs in the options market result in lower incentives for informed market participants to trade in stocks that have options listed than in stocks without traded options. We also hypothesize that the underlying market for optioned stocks is informationally more efficient than that for nonoptioned stocks. Our cross-sectional tests of U.S. market data show that the level of insider trading is significantly lower, as a percentage of total trading volume, for optioned stocks than for nonoptioned stocks during months when insider trading is intense. When we compare the magnitude of stock price adjustments to insider trades, our results indicate that the price reaction to insider trading events is less pronounced for optioned stocks. Both pieces of evidence are consistent with the view that informed trading is less likely to occur and its price effect is better anticipated in the underlying market for optioned stocks than for nonoptioned stocks. Previous research has shown that in the U.S. markets, the market for a particular stock benefits in several ways when options on that stock are listed on the exchange. These benefits in the market for the underlying stock include significant price appreciation, increased trading volume, and reduced price volatility. The effects of insider trading in the underlying stock because of options listing, however, have not been examined. We analyze cross-sectional differences in insider trading patterns and stock price reactions to insider trades in optioned and nonoptioned stocks.Options markets provide several practical advantages to informed traders. First, options investment allows higher leverage than trading in the underlying stock. Second, option traders enjoy the borrowing and lending rates implied in option prices, which are comparable to rates available only to institutional traders. Third, short-sale restrictions can be circumvented in the options market. Fourth, informed traders may incur lower legal risks because of the lack of explicit disclosure laws in the options market. Furthermore, existing insider trading laws are not as strictly enforced in the options market as they are in the stock market. All these reasons suggest that, given a choice, an insider would rather trade in the options market than in the market for the underlying stock. Because insiders in nonoptioned stocks do not have the same choices, we tested whether insider trading in this market is higher than in the market for optioned stocks.We used insider trading data on optioned and nonoptioned stocks from the U.S. SEC's Ownership Reporting System summary files. To ensure that the trades were driven by material nonpublic information, we used months we defined as “intensive insider trading months” (months in which three or more insider trades occurred in the same direction and none occurred in the opposite direction) in both samples. Our results indicate that, as a percentage of total trading volume, the average level of insider trading is lower in optioned stocks than in nonoptioned stocks. These results persisted even after differences in size and trading volume between the two samples had been accounted for.We propose that the incentive to gather information is greater for optioned companies because returns in the options market can be considerably higher than returns in the stock market. Arbitrage opportunities arise if the underlying stock market does not reflect that information. Such opportunities should translate into improved price discovery in the market for the underlying stock. Previous research shows that earnings announcements, which are public information, are more rapidly reflected in optioned-stock prices than in nonoptioned-stock prices. We tested the extent to which optioned stock prices reflect private information.We examined insider trading because it is not public until after the fact. Compared with a public event, such as an earnings release, the information content of an insider trade is difficult to anticipate for several reasons. First, knowledge about most insider trades is not available to the public until after the trade has been reported to the SEC. Second, information-based insider transactions are not predictable. Third, the securities analysis industry has invested considerable physical and human capital in collecting, processing, and interpreting earnings-related data. Therefore, when we tested whether the information underlying an insider trade is better anticipated in the market for optioned stocks, we were actually subjecting the information hypothesis to a stronger test than testing the information effect of a public event.We estimated and compared for optioned and nonoptioned stocks the excess returns in and after months with intensive insider trading. Our results show that, whereas insiders investing in nonoptioned companies earn significantly positive excess returns over a one- to six-month interval following their stock transactions, insiders in optioned companies receive zero excess returns over the corresponding periods. The excess returns for nonoptioned stocks are significantly higher, even after control for market capitalization and the level of insider trading.These results thus imply that the insider trades in nonoptioned stocks have higher information content than those in optioned stocks. From a practical standpoint, caution should be used in tracking insider trading data. Insider trades may be information or liquidity motivated. Insider trades in optioned stocks may be primarily liquidity motivated, whereas those in nonoptioned stocks may be liquidity as well as information motivated. Options, if available, may be a better vehicle for informed trading.