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How Do Informed Traders Trade Based On Insider Information?
Traders Magazine Online News, May 1, 2019
Which option trading strategies are most likely to give informed traders the best returns for their insider information? And which are they most likely to use?
Existing research suggests inside traders tend to gravitate toward the options markets, as options can potentially offer higher returns and their transactions may be easier to hide. The presence of informed investors in the options market may also be evidenced by informed trading activity ahead of corporate announcements.
But while previous research has identified the existence of informed trading in the options markets, no known research has offered insights into the specific strategies informed investors are likely to use, until now.
In “How Do Insiders Trade?” by Patrick Augustin (McGill University, Desautels Faculty of Management), Menachem Brenner and Marti G. Subrahmanyam (New York University), and Gunnar Grass (HEC Montréal), the researchers suggest a framework for how investors might best leverage their private information in the options market.
Not All Insider Tips Are The Same
The researchers suggest that informed investors may receive private, noisy tips that can vary by their timing and potential impact on the markets. They therefore analyze how informed investors trade on news tips in the options market based on (1) the expected timing of announcements, and (2) the potential impact of the announcement on stock prices.
For instance, an investor who receives private information about a scheduled earnings announcement will know when the news will be made public, but will likely not be certain on the impact of that news on stock prices and returns. In contrast, an investor with inside information on the terms of a merger or acquisition deal may be able to predict that it will have a large impact on price, but may not know the exact timing of the announcement.
The combination of these signals determines the strategies inside traders are likely to use as well as their returns in the options market.
Researchers constructed a sample of 30,975 of, what they term, “significant corporate news” (SCN) events spanning from 2000-2014, using the RavenPack news database, which converts news and social media into structured granular data and indicators. They divided these significant events into twelve categories, based on announcement characteristics.
They simultaneously used Compustat’s Capital IQ Key Developments and quarterly earnings announcement dates, along with OptionMetrics historical options data. “OptionMetrics is the standard for anyone that wants to look at equity options data. We used it extensively for our past research on the prevalence of insider trading, as well as in this most recent research.” In analyzing the data and arriving at the maximum expected returns, the researchers assessed combinations of option types, strike prices, and maturities that inside traders might leverage from informed trading on a tip or noisy signal.
They also accounted for the fact that informed investors may deviate from options strategies expected to be most profitable in an effort to “conceal” their informed trades.
They propose a volume-based measure of informed trading to predict returns and sentiment. In assessing bid-ask spreads and minimum option prices, the researchers ranked the top option strategies that are likely to maximize returns for tips indicating a potential increase in stock price, and which are also likely have an expected news date. The measure they developed is based on the volume of options that would yield “high” expected returns from a top quantile of achievable returns. “…we propose new measures of informed trading implied by our framework. In particular, we construct the ratio of informed call (put) volume to aggregate call (put) volume, where informed volume is defined as trading volume in options delivering high expected returns. We show that these measures improve the cross-sectional predictability of excess stock returns and news sentiment over existing measures of informed trading,” say the researchers.
The researchers say they hope their paper provides a framework “useful to regulators for the detection of abnormal trading activity, to corporations to be more alert to the leakage of information about their announcements, and to investors for the prediction of excess stock returns.”
The full paper is available online.
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