Can Option Trading Activity Offer Insights On Future Stock Returns When It Comes To IPO Valuation?

Can Option Trading Activity Offer Insights On Future Stock Returns When It Comes To IPO Valuation?

Can Option Trading Activity Offer Insights On Future Stock Returns When It Comes to IPO Valuation? by Mary Garrett

Are there important links between the options market and the stock market that financial professionals can benefit from knowing? And can they glean insights about subsequent stock returns from option demand?

Financial professionals and academics have debated these questions, as well as the influence of IPOs on the markets for years. Theoretical papers have argued that the listing of options on a firm’s stock can have important economic effects on its equity.

A recent research paper titled “Options on Initial Public Offers” highlights consistent links between the price of options and stocks immediately following the introduction of IPOs. It also looks at the effects of a firms’ venture-backed-funding status and its underwriter’s reputation on the company’s stock price.

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How IPO Introductions Affect Stock Returns

Researchers Chayawat Ornthanalai (University of Toronto), Thomas Chemmanur (Carroll School of Management), and Padmaja Kadilyala (Pace University) found a significant decrease in stock returns immediately following options listings. They found that investors that bought the long-dated maturity put options on recent IPO stocks and held them until expiration garnered an average return of 6.3% per month. To come to this conclusion, the researchers studied options listings on IPOs from 1996 through 2011 with data obtained from OptionMetrics. The study excluded IPOs after 2008 to allow at least three years to follow the option listings history. The data enabled researchers to identify option introduction dates, as well as the volume of the put and call options that traded on the IPO stock. They also obtained security prices and trading information from the Center for Research in Security Prices (CRSP). Their final sample consists of 2,503 firms across 29 industries.

Researchers attributed the decrease in IPO stock returns after option listing to the fact that short-sale constraints are relaxed when options are listed. It is hard to short sell IPO shares after a firm goes public because there are not many shares that investors can borrow prior to shorting. Even though these short sellers can locate the IPO shares to borrow, the borrowing cost are often very high thereby deterring them from entering into their short positions. However, when options are listed, investors can simply buy a put option on the IPO equity, essentially shorting, but with limited liability.

The Effects of Venture-Backed Underwriters on IPO Prices

Researchers also found that the top characteristics that affected the listing of IPOs, and had the most influence over the price impact, were the IPO’s venture-backed status and the reputation of the firm’s underwriter.

They found that venture-backed IPO firms suffer the most because they are often over-valued after the initial public offering and tend to have options listed soon after going public. Meanwhile, IPOs listed by highly-respected underwriters are associated with longer time to option listing and less price depreciation after options are introduced. This is consistent with the view that when highly respected underwriters take the firm public, there is less information asymmetry in the IPO pricing process and therefore lesser disagreement among investors on the stock price following the IPO.

To arrive at their results, researchers examined the effect of option listing on stock returns using a regression analysis. Their dependent variable for this analysis is the weekly return on the IPO firm’s stock around option listing, measured over two event windows: a shorter event window of [-12, +12] weeks, and a longer event window of [-12, +52] weeks centered on the option listing date. After controlling for time varying firm-specific variables such as momentum, size, volume, and volatility, they found that option listing has a significantly negative impact on the weekly return on the underlying IPO firm’s stock returns, regardless of whether they are measured over the shorter or longer event window. More specifically, the baseline regression results suggest that relative to the weeks before options are listed, IPO’s stock returns, on average, decrease by 134-160 basis points per week after options have been listed.

Researchers obtained underwriter reputation ranking from data collected from Jay R. Ritter, an eminent scholar at the University of Florida, Warrington College of Business Administration. On that subject, the lead underwriter of each IPO is mapped to the reputational scale of 0 (lowest) to 9 (highest). The mean and median underwriter reputation score in their sample was 7.55 and 8, respectively. Only underwriters that are ranked with the score of 9 are considered highly reputable.

“In analyzing the data over a 12 year history, our research shows that the introduction of options on firms that have recently gone public can significantly influence their post-IPO stock price performance. This information should provide academia and investors with insights into the options and stock market and enable them to make more informed decisions,” said Professor Chayawat Ornthanalai. “We looked at OptionMetrics Ivy DB data to arrive at these results because it offered a clean and easy-to-use data platform and is considered to be the standard in academia.”

For more on this and other working papers, visit:

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