Informed Trading Around Stock Split Announcements: Evidence From The Option Market

Philip Gharghori

Monash University; Financial Research Network (FIRN)

Edwin D. Maberly

Monash University

Annette Nguyen

Deakin University

October 12, 2015

Journal of Financial and Quantitative Analysis (JFQA), Forthcoming

Abstract:

Prior research shows that splitting firms earn positive abnormal returns and that they experience an increase in stock return volatility. By examining option-implied volatility, we assess option traders’ perceptions on return and volatility changes arising from stock splits. We find that they do expect higher volatility following splits. There is only weak evidence though of option traders anticipating an abnormal increase in stock prices. We also show that our option measures can predict both stock volatility levels and changes after the announcement. However, there is little evidence that they can predict the returns of splitting firms.

Informed Trading Around Stock Split Announcements: Evidence From The Option Market – Introduction

The option market is a venue for informed trading. Prior research has identified a number of reasons why informed investors may prefer to trade equity options rather than the underlying stock. Such reasons include higher leverage and ease of shorting (Black (1975)). An impressive amount of recent empirical work has demonstrated evidence of informed trading in options for both the cross-section of stocks and around firm specific events. Research that considers the cross-section of stocks includes Bali and Hovakimian (2009), Cremers and Weinbaum (2010), Roll, Schwartz and Subrahmanyam (2010), Xing, Zhang and Zhao (2010), Johnson and So (2012) and An, Ang, Bali and Cakici (2014). Earnings announcements are studied by Diavatopoulos et al. (2012), Jin, Livnat and Zhang (2012) and Atilgan (2014). Lastly, Hayunga and Lung (2014), Lung and Xu (2014) and Lin and Lu (2015) consider analyst recommendations and Chan, Ge and Lin (2014) examine M&As.

We contribute to this literature by investigating informed trading in options around stock split announcements. There are two key reasons why stock splits are a particularly interesting event to examine in the context of informed trading. First, unlike for example earnings announcements, which are scheduled events, stock splits announcements are unanticipated events that the market should not be aware of in advance. This allows us to more cleanly analyze whether informed option investors are trading in anticipation of the impending event. Second, prior research shows that stocks experience changes in both the level of their returns and the volatility of their returns due to splits. This provides us with a novel opportunity to examine the expectations of option traders on both return and volatility changes arising from the same event.

The specific observations of prior research on return and volatility changes due to splits that inform our analysis are as follows. There is, on average, a strong positive reaction when firms announce splits (Grinblatt, Masulis and Titman (1984), Chern, Tandon, Yu and Webb (2008) and Lin, Singh and Yu (2009)). Positive return drift that lasts at least one year after the split announcement is observed (Ikenberry, Rankine and Stice (1996), Desai and Jain (1997) and Ikenberry and Ramnath (2002)). However, this drift is conditional on the period examined (Byun and Rozeff (2003)) and it is driven by the relatively short period between the split announcement date and the split effective date (Boehme and Danielsen (2007)). Stock volatility increases when splits are announced (Ohlson and Penman (1985)), which is a common occurrence for any unscheduled and meaningful corporate announcement. Finally, there is an increase in stock volatility after splits are effected (Ohlson and Penman (1985), Dravid (1987) and Koski (1998)).

We examine option-implied volatility around 1,780 stock split announcements for the period 1998 to 2012. We draw inference on option traders’ perceptions on volatility changes when splits are announced and after they are effected, and on split announcement returns and longer-term return drift following announcements. We document a consistent increase in implied volatility for the most speculative short-dated options in the days preceding the split announcement. We also observe elevated levels of option trading volume prior to the announcement. These findings are indicative of informed trading in options. More pointedly, they suggest that news about impending split announcements has leaked and that option investors are trading on this information.

Throughout the analysis on option traders’ volatility perceptions, we consider implied volatility changes in call and put options, separately. Prior to the announcement, we find that implied volatility increases in both short maturity calls and puts. This indicates that the trading is driven by an expected increase in stock volatility on and soon after the announcement. In contrast, if the increase in implied volatility was only observed in calls, this would imply a directional bet on positive announcement returns. After a large and expected increase in implied volatility on the announcement date, call and put implied volatility increase again on the next day but only in long maturity options that expire after the effective date. This suggests that option traders expect that stock volatility will increase after splits are effected.