Insider Trading When an Underlying Option is Present

Abstract

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.

Keywords: Portfolio Management, equity strategies, Portfolio Management, trading and execution