Tipping and Option Trading

Author(s): Pei Peter Lung and Pisun Xu

Source: Financial Management , FALL 2014, Vol. 43, No. 3 (FALL 2014), pp. 671-701
Published by: Wiley on behalf of the Financial Management Association International

Stable URL: https://www.jstor.org/stable/43280530

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 Tipping and Option Trading
Pei Peter Lung and Pisun Xu*

This study examines options' market behavior before analysts' initiations. We find abnormal
trading activity in the options market several days prior to the release of analysts ' initiations.
Informed traders recognize the content and timing of the initial recommendations. We determine
that informed trading is attributed to information leakage rather than savvy investors ' stock-
picking ability. We also find a significant information transmission from the options market to the
underlying equity market around the event. Our results are consistent with the tipping hypothesis
and confirm the informational role of equity options.

The informational role of derivatives has emerged as an important economic function.1 A

growing body of literature has studied the effectiveness of the options market for information
and price discovery (Donders and Vorst, 1996; Amin and Lee, 1997; Donders, Kouwenberg, and
Vorst, 2000; Isakov and Perignon, 2001 ; Roll, Schwartz, and Subrahmanyam, 2010; Hayunga and
Lung, 2014). This paper contributes to this body of knowledge by investigating informed trading
in the options market around the release of analysts' initiations.
The recent literature provides evidence concerning information leakage prior to financial
analysts' recommendations. Irvine, Lipson, and Pucket (2007) develop a tipping hypothesis
and find supporting evidence. They argue that financial analysts have incentives to prerelease
their research to select investors as the cost of research can be recovered from commissions
on the trading activity of brokerage clients who benefit from the research. They find elevated
institutional buying in the stock market prior to public distribution of initial recommendations.
Markov, Muslu, and Subasi (201 1) further confirm the tipping hypothesis by documenting new
evidence regarding interactions between informed investors and analysts prior to initiations. They
find that analyst-hosted conferences govern private information exchanges among companies,
analysts, and select investors prior to analysts' initiations.
This emerging body of literature regarding informed trading prior to analysts' initiations has
focused mainly on the stock market. It is intriguing to examine whether informed investors
also use options to exploit their information advantage. Previous literature indicates that the
options market offers significant advantages to informed traders as opposed to the stock market.
A few studies confirm that in the absence of market completeness, financial leverage, short
sale constraints, and built-in downside protection may induce informed traders to trade options
instead of underlying assets (Black, 1975; Diamond and Verrecchia, 1987; Back, 1992; Mayhew,
Sarin, and Shastri, 1995). Easley, O'Hara, and Srinivas (1998) argue that the options market is
more attractive as informed traders can hide themselves better among uninformed traders due
to the availability of multiple options contracts for each stock. Cao (1999) argues that agents
with information about future contingencies should be able to trade more effectively on their
information in the presence of options. Hu (2012) finds that permanent price information in stock

*Pei Peter Lung is the Denver Clearing House Endowed Chair Professor of Finance at the University of Denver in Denver,
CO. Pisun Xu is an Associate Professor of Finance at the University of Denver in Denver, CO.
1 See the statistical release of Bank for International Settlements - "OTC Derivatives Statistics at End-June 2013," which
is available at http://www.bis.org/publ/otc_hyl31 1. pdf.

Financial Management • Fall 2014 • pages 671 - 701

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672

order flow is primarily i

preferred venue for infor
As one of the importan
unique and valuable sett
contents of an analyst's r
announcements. Initiatio
released to the general p
ascertains empirically wh
If analysts leak the info
knowledge of the timing
substantial and the poten
The value of such inform
Thus, analysts' initiation
Our sample includes 1,
first examine option tra
call-to-puttrading volum
in the forthcoming anal
beginning seven days pri
stock market during our
We also examine how inf
to analysts' initiations b
findings indicate a signifi
equity market around th
we find a 43% transmis
market returns for initi
information transmission
analysts' initiations. Thes
trading private informa
Bali and Hovakimian, 20
In addition, we analyze w
investors' stock selection
trading attribut could be
analysts may use similar
leak their initial recomme
tradingactivity in the op
informed trading should
along with the timing of
abnormally prior to analy
related to the target price
picking ability, attributes
analysts' initiations.
Furthermore, our simula
from trading in the opt
before an upcoming buy
publicly released, they c
four times the return in
5.09% in seven days by b

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Lung & Xu » Tipping and Option Trading

This paper is the first study t

activity around analysts' initiat
market is an important venue o
are of interest to academia as i
among investors, particularly w
and Nicodano, 2001; De Franc
regulators. Our study indicates
in the options market. Our find
trading and prompt regulators t

I. Hypotheses

This study links two strands of

the information leakage of fina
the options market is an attract
regarding whether and how a
is announced to the public. The
information leakage prior to an
information role of the options
rewards associated with analys
heightened informed trading ah
A number of previous studies
around informational events (A
and Griffin (2005) find that the
informed trading prior to takeo
if there is information leakage
disseminate their private inform
as follows:

Hypothesis 1 : If information le
for informed investors to
should trade options in the d
prior to any public announ

The previous literature examin

stock market and finds that op
et al., 1998; Pan and Poteshman
confirms that options order fl
maker's delta hedging transactio
the options market. We hypoth
first,resulting in information t
analysts' initiations. Our second

Hypothesis 2: With the informa

should have a substantial in
an increase in the informat
the public announcement.

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 674

Moreover, if financial an
announcements, these sel
research report. Irvine et
to specific characteristics
returns and, as such, grea
analysts' reports. Previous
(Brav and Lehavy, 2003; A
prices is positively correla
disclosed in the analysts' r
that abnormal option tradi
prices. Our third hypothe

Hypothesis 3: The magnit

related to the content
disclosed in the report

II. Methodology

To investigate option tradi

1) the option-implied pri
calculations for these two

A. Option Metrics
1. The Option-Implied P

In this subsection, we out

implied price ratio. Unde
European options, the put

So = c - p + k;tT + d, (l)
where So is the stock price, C is the call opti
r is the continuously compounded risk free
value of the dividends during the life of th
early exercise premium. Following the ana
(Ofek, Richardson, and Whitelaw, 2004; Bat
as

S = C-P + Ke~rT + D- EEPcaii + EEPpuU (2)

where S is the option-implied stock price based on the information in the

and EEPput are the early exercise premiums for American call and put

2 In our final sample, there is a single estimate for the option-implied price per stock per da
for details about data filtering and estimation procedures.
3 Although this approach is widely used in the literature, it does not consider the market frictio
and the estimates for the early exercise premium may not be perfect. In a robustness analys
for the option-implied price based on option boundary conditions. We find consistent result

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 Lung & Xu * Tipping and Option Trading

We estimate the early exercise

Whaley (1987).4 All the put-cal
Equation (2). It is worth noting
EEP Caii disappear.
We measure the option-implied

ISU = log (Šu/Sē,t), (3)

where Sift is specified in Equation (2) an
option-implied stock price equals the actu
optimistic than the equity market, ISiit

2. The Call-to-Put Volume Ratio

The second measure of option trading activity around analysts' initiations is the call-to-p
trading volume ratio {CIP). The predictability of CIP has been documented in the previ
literature (Easley et al., 1998; Pan and Poteshman, 2006; Roll et al., 2010). This paper measur
CIP as buyer initiated call trading volume divided by buyer initiated put trading volume. For st
i with call and put option trading volume on dayř, we compute the ratio as follows:

_ Buyer Jnitiated -Call -Trading- Volume

l,t _ Buyer Jnitiated .Put .Trading -Volume
We identify an option as buyer initiated if the trade price of the option is equal to the ask s
of the quotes or greater than the midpoint of the quotes when the transaction occurs.

B. Event Study Procedure

This subsection describes the event study procedure for examining the abnormal stock an
option trading behavior around analysts' initiations (Mikkelson and Partch, 1988; Boehmer,
Poulsen, and Musumeci, 1991; Liang, 1999).

1. Stock Market Abnormal Returns

To analyze stock price behavior, we first specify a benchmark return and define the daily
abnormal price change in the event window as the difference between the actual return and the
benchmark return. We use the four-factor model to generate benchmark returns:

Ri,t = (li + ßm Rmj + ßsMßSMBt + ßnMLHMLt + ßy' fpUMDt + £/,/, (5)

where is the log return for common stock i on day t, Rm is the excess market return based on
the CRSP value-weighted market index, SMB is the difference between the daily returns on the
portfolios of small and large stocks, HML is the difference between the daily returns on stock
portfolios of high and low book-to-market values, and UMD is the difference between the daily
returns on stock portfolios of high and low momentum. ei>t is the random error term of stock i on
day t. We define the announcement day as Day 0 and estimate the model parameters based on an

4 We also use Ho, Stapleton, and Subrahmanyam (1994). The test results are similar.

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 676

estimation window of a 1
for common stock i durin

ARi t = Ri j - (a¡ + ßm

Following Boehmer et al.

abnormal returns as follow

jtsARij/N
test statistic t = . l~l . (7)

y / N(N - 1) | - l/tf X
In Equation (7), SAR¡ is the standardized abno

SAR,,, = (8)
CT/

where a, is the standard deviation of abnormal returns for stock i during the estimation period.5

2. Abnormal Option-Implied Price Ratios

We analyze the abnormal behavior of option-implied price ratios based on the relationship
between the ratios and actual stock returns. Similar to the estimation of abnormal stock returns,
our approach specifies a benchmark relation between the implied ratios and actual stock returns.
The benchmark relation between option-implied price ratios and actual stock returns for security
i is specified as

ISitt = oti + + ei,ti (9)

Where ISiit, as specified in Equati

implied price and the actual stock p
to the construction of the benchma
based on a 150-day period from D
stock i is estimated from

AISu=ISu-(āt+ĶRu). (10)
The test statistic for AISiļtis computed i

5 We employ the standardization method developed

standardized by the estimation-period standard dev
divided by the cross-sectional standard deviation to
of the Patell (1976) method and the cross-sectional m
stock returns with large standard deviations and al
more robust with respect to possible volatility chan

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 Lung & Xu » Tipping and Option Trading

C. Abnormal C/P

We compute the abnormal call-to-put volume ratio (C/P) on day t and its standard deviation
according to the average of CIP. The average of daily C/P for stock i is estimated as

cjpi= g c/p,,/l50. (11)

/=-170

The abnormal C/P for stock i on day t is

ACPij = C/Pit - ~ČJPi. (12)

The test statistics of ACPiyt are calculated i

III. Data

A. Analysts' Initiation Data

Analysts' initiation data are from Briefing.com, a major and growing company providing real-
time information in the financial markets.6 Instead of relying on the Institutional Brokers Estimate
System (I/B/E/S) database, we use Briefing.com as the data source as it reports analysts' target
prices and provides the ratings along with the initial recommendations, enabling us to test the
proposed hypotheses in this study. As different brokerage firms provide different terms regarding
their recommendations, we standardize the initial recommendations into Buy and Sell Initiations.
The detailed procedure is described in the Appendix.
We account for analysts' clustering and piggybacking problems in our sample. Similar to Welch
(2000) and Demiroglu and Ryngaert (2010), we identify a list of analyst initiations of publicly
traded stocks that received no analyst coverage for at least 170 days from any brokers reported
on Briefing.com from 2009 to 201 1 . It is worth noting that our sample of initiations includes two
groups of firms: 1) first ever initiations and 2) regular initiations that had prior analyst coverage,
but no listing of coverage in the past 170 days on Briefing.com.
We further limit our sample to initiations that are not associated with corporate events from 20
trading days prior to the initiation announcement date. This restriction addresses the piggyback-
ing problem uncovered by Altinkiliç and Hansen (2009). We identify the piggybacking events
based on I/B/E/S, Securities Data Compnay (SDC), Mergerstat by Factset, Center for Research
in Security Prices (CRSP), and Factiva.com. Events include earnings news, guidance, reports, fi-
nancial news, security issuances, stock repurchases, dividends, dividend changes, capital raising,
corporate restructuring, asset sales, workforce changes, divestitures, mergers, new clients, new
contracts, new products or projects, outsourcing, product withdrawals, product delays, sales of
stakes in another company, accounting policy changes, chief executive officer (CEO) discussions,
governance actions, lawsuits, and management changes.
After filtering the initiations from Briefing.com according to the criteria mentioned above, we
obtain 1,734 Buy Initiations and 283 Sell Initiations from 2009 to 201 1. Financial analysts tend
to issue more buy initial recommendations than sell initial recommendations during our sample
period.

6 The data source is http://www.briefing.com/investor/calendars/upgrades-downgrades/. There are more than one million
subscribers at the end of the year 201 1 .

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 678

B. Stock and Option D

The daily stock return dat

New York Stock Exchang
we remove indicative stoc
imbalances.
The intraday option data are from the Option Price Reporting Authority (OPRA). OPRA
collects intraday option quote and trade messages, adds a sequence number to each message, and
subsequently tags each quote with a code indicating whether the quote represents a national best
bid and/or offer. At any given point in the day, an option series' National Best Bid (NBB) is the
highest bid price from all participating option exchanges. The National Best Offer (NBO) is the
lowest posted offer. We exclude nonfirm quotes, as well as those flagged as closing quotes, when
calculating our National Best Bid and Offers (NBBOs) since these quotes are only indicative. In
addition, following Ofek et al. (2004) and Battalio and Schultz (2006), we apply a set of filters
to maximize the option data quality and use the filtered sample in the analysis.7
This study uses the intraday data for both stocks and options to calculate the option-implied
stock price (5). We employ the aggregate daily trading volume to calculate the call-to-put volume
ratio {CIP). To ensure that both stock and option quotes represent prices at which investors could
actually trade, we delete observations with the best bid quote higher than the best offer quote.
For each option series, we use the mid- values of NBBO option quotes and stock quotes at 4:00
p.m. (EST) to estimate the option-implied stock price (S). If, on a given date and for any given
stock, there are multiple pairs in the filtered sample, we calculate the average of the implied stock
prices for each day and stock. Thus, there is a single estimate for the option-implied stock price
per stock per date in the final sample.

C. Sample Descriptive Statistics

Table I reports the descriptive statistics for firms with initial buy recommendations (Buy
Initiations) and firms with initial sell recommendations (Sell Initiations). The estimation window
is the benchmark period from Day -170 to Day -21 prior to the analysts' initiations. During
the benchmark period, the average daily return for Buy Initiations is 0.09% with a volatility of
3.54%, while it is 0.01% with a volatility of 5.25% for Sell Initiations. These results suggest that
analysts tend to issue buy recommendations for the stocks with higher returns and lower volatility
prior to the initiations, and vice versa. Both Buy and Sell Initiations samples have an average
firm size of about $9 billion, indicating that firm size does not affect analysts' initiations.
The implied price ratio (IS) during the benchmark period is -0.31% for Buy Initiations and
-0.97% for Sell Initiations. This finding implies that financial analysts recommend investors
buy those stocks with higher implied prices prior to the initiations. These statistics support the
information role of the options market. It is worth noting that IS is negative for both groups due
to the short sale constraints in the stock market. When the option-implied price is greater than
the actual stock price, investors can long the stock and construct a synthetic short position in the
options market. However, if the option-implied price is less than the actual stock price, investors
may not be able to short the stock due to short sale constraints. Thus, the option-implied price

7 The filters that we apply to enhance the option data quality are: 1) on each date, we remove the thinly traded options
that have either zero open interest or an absolute value of delta smaller than 0.02 or greater than 0.98; 2) on each date,
we remove call and put options that do not have a corresponding put or call option with the same maturity and exercise
price; 3) we eliminate options with maturities of less than five days or greater than 90 days to mitigate the volatility
term-structure effect; 4) we eliminate any option that has a bid-ask spread that is greater than 50% of the option price to
reduce the recording errors and options with very low liquidity. We use the filtered sample in the analysis.

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Lung & Xu • Tipping and Option Trading

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 680

has a tendency to be low

Sell Initiations.
The average call to put v
Sell Initiations (5.74) dur
more call options for Buy
consistent with the infor
To determine whether in
we construct a target pr
the target price disclosed
calculated as follows:

TR - Target Pr icep
Actual Stock Price -' '

where Target Prices is the target price announced on the event day and Actual Stock Price- ' is
the actual stock price one day prior to the event day. The target price ratio (TR) is 36. 10% for Buy
Initiations and -13.61% for Sell Initiations, indicating that the target prices are consistent with
the direction of the analysts' recommendations. These two numbers also suggest that analysts
tend to issue stronger recommendations for Buy Initiations than for Sell Initiations.
Table I also reports the descriptive statistics of four investment signals that are found in the
literature to have close relationships with future stock returns (Jegadeesh et al., 2004; Cooper,
Guien, and Schill, 2008). These signals include standardized unexpected earnings (SUE), analysts'
earnings forecast revisions to price ratio (FREV), total asset growth rate of the previous quarter
(ATG), and return momentum (MOM). SUE is calculated as unexpected earnings in the previous
quarter scaled by the standard deviation over the previous eight quarters. FREV is tabulated as
the rolling sum of the previous six months earnings forecast revisions scaled by price. ATG is
calculated as the percentage change in total assets for the preceding quarter. MOM is computed
as the cumulative market-adjusted return for the previous six months to 21 days before the
initiations. Table I demonstrates that Buy Initiations have higher MOM , FREV, SUE , and ATG
than Sell Initiations, suggesting that financial analysts incorporate these firm characteristics in
issuing their recommendations.

IV. Empirical Results

A. Informed Trading Prior to Analysts' Initiations

To verify the magnitude of price responses and incentives for informed trading in our sample,
we examine the abnormal stock returns (AR) in the event window of -20 to -1-5 days around the
public release of analysts' initiations. Table II indicates that Buy and Sell Initiations are associated
with significant event day returns of 0.56% and -0.70%, respectively. For Buy Initiations, we
find that AR becomes significant on Day -2, peaks on Day 0, and remains significant through
Day 1. For Sell Initiations, AR remains significant and decreases from -0.26% on Day -2
to -0.70% on Day 0. The results suggest that abnormal trading behavior in the stock market
predates the initiation announcements, confirming Irvine et al. (2007), Juergens and Lindsey
(2009), Christophe, Ferri, and Hsieh (2010), and Markov et al. (201 1).
Next, we examine abnormal trading behavior in the options market prior to analysts' initia-
tions. Table II presents the abnormal option-implied price ratio (AIS) and the abnormal call-to-put

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Lung & Xu « Tipping and Option Trading

Table II. Abnormal Trad

The table presents the abnormal

abnormal call-to-put volume rati
AR is calculated based on Equat
Tests of significance are based on

Buy Initiations Sell Initiations

Day

-20 -0.02% 0.03% 0.18 0.04% 0.05% -0.60

-19 0.05% -0.01% 0.31 -0.03% -0.02% 0.52
-18 -0.04% 0.00% -0.27 -0.01% 0.02% -0.71
-17 -0.09% 0.03% 0.53 -0.04% -0.01% -0.82
-16 0.04% -0.03% -0.36 0.09% 0.04% 0.82
-15 -0.01% -0.04% 0.66 0.08% -0.03% 0.38
-14 0.01% 0.01% 0.40 0.11% -0.01% -0.97
-13 -0.09% -0.05% -0.25 0.08% 0.04% 0.76
-12 0.01% -0.02% -0.16 0.08% 0.06% 0.83
-11 -0.03% 0.05% 0.14 0.10% -0.04% -0.09
-10 -0.01% 0.03% 0.25 0.09% 0.04% 0.75
-9 -0.04% 0.01% 0.65 0.08% -0.07% -0.68
-8 -0.02% -0.01% 1.19 0.06% -0.12% -1.41*
-7 0.01% 0.09% 1.45* 0.02% -0.19%* -1.61*
-6 0.02% 0.17%* 1.81* -0.02% -0.23%* -1.92*
-5 0.01% 0.20%* 1.94* -0.01% -0.22%* -2.37*
-4 0.01% 0.22%* 2.16* -0.10% -0.27%* -2.42*
-3 0.02% 0.25%* 2.54* -0.17% -0.31%* -2.86*
-2 0.13%* 0.27%* 2.61* -0.26%* -0.35%* -2.89*
-1 0.22%* 0.37%* 3.06* -0.37%* -0.36%* -3.70*
0 0.56%* 0.13% 3.59* -0.70%* -0.29%* -3.93*
1 0.19%* -0.05% 3.10* -0.57%* -0.21% -3.16*
2 0.08% -0.02% 2.19* -0.16%* 0.05% -2.62*
3 -0.04% -0.07% 0.56 -0.08% -0.04% -1.09
4 -0.10% -0.06% -0.10 -0.03% 0.03% -1.24
5 -0.09% -0.04% 0.77 0.06% -0.02% -0.26

* Significant at the 0.10 level.

volume ratio (ACP) for both Buy Initiat

nificance. For Buy Initiations, we find
elevated through Day -1. This result in
formation in the options market ahead
increases from 1.45 on Day -7 to 3.59 o
jump in the prerelease period. For Se
-0.29% on Day 0. In addition, as ACP be
that the buyer-initiated put options star
keep rising to Day 0.
Collectively, Table II demonstrates abn
analysts' initiations supporting Hypothe
put volume ratio increase prior to Buy I

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 682

suggests that informed i

note an abnormal tradin
results complement two
and 2) information conte
Figure 1 depicts the abn
(AIS) during the Day -2
days preceding the publ
days before the announc
markets. The finding in t
(Irvine et al., 2007; Mark
Hypothesis 1 , informed i
in the options market. T
recommendations. In add
initiations earlier than th
Figure 1(b) reports that
moves into negative terr
and trade
info on private
Figure 2 presents the a
ACP starts to increase (d
recommendations. Again,
the prerelease period and
initiations.

B. Information Flow
To examine how inform
analysts' initiations, we
Acharya and Johnson (20
We regress the two opt
the stock market return
variable, the specificatio

=r°*i +¿th +¿íwi *r*i +h . (M)

.^J„, L^'d, l>s_L* L R i,,-* *-• L^J,,
In this equation, R is the stock return and n is the number of lags, uais is the inno
options market. It is defined as an independent shock arriving in the options market
not pertinent or appreciated by the stock market. This vector autoregression model ens
the measure for uais¡ , is not biased in the presence of reverse causality. We choose
model based on our findings in Table II, which indicates that the options market re
information approximately seven days before the event.9 We use the Newey-Wes

8 For literature regarding information leakage prior to analysts' recommendations, please see Irvine et al.
and Lindsey (2009), Christophe et al. (2010), and Markov et al. (201 1). For publications regarding inform
in options trading, please see Easley et al. (1998), Chakravarty et al. (2004), Pan and Potesman (2006),
Cremers and Weinbaum (2010), Roll et al. (2010), and Xing et al. (2010).
9 Since the choice of the number of lags could be arbitrary, we also conduct robustness check using fiv
to AIS and find qualitatively similar results.

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 Lung & Xu » Tipping and Option Trading
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 Lung & Xu « Tipping and Option Trading

to estimate the model. The nu

set at two.

In the second stage, we regress the stock return on the announcement day on the options market
innovations from Equation (14) and lagged stock returns. The specification is

n n

Ri.t
k=0 k='

where bk measu
and èf is the in
dummy variable
We examine J2
flows from the
the stock marke
unconditional w
flow in the stoc
are not driven b
variables to allo
- 170 to Day +7
It is worth clar
flow, bkD, whic
into the stock r
Table III presen
tion parameter
coefficient is su
5%. For Sell Ini
from the optio
more informat
sale constraints
magnitudes of t
4% to 6%. We al
Ylk=' ck> is not
Overall, the test
options to the s
suggest that inf
the options mar

C. Stock-Pick

After documen
we further exa
informed tradin
Informedtradi
and financial an
analysts could le
Analysts could
pany's managem

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686

Table III. Informati

Prior to Analys

This table presents the re

ket prior to analysts' init
J2k=i + <%(EAD)t] • Ri,t-k
tions market, estimated ba
event day and 0 otherwise.
that the options market re
Newey-West (1987) GMM
covariance matrix in the pr

Buy Initiations Sell Initiations

AIS

EL bk 0.05 (23.87)* 0.04 (20.51)'

EL, b£ 0.37 (7.61)* 0.43 (5.36)*
ELi<* -0.04 (-14.20)* -0.04 (-9.20)*
EL cf -0.03 (-0.66) 0.06 (0.26)
ACP

EL bk 0.07 (5.38)* 0.08 (12.05)*

EL b? 0.04 (4.47)* 0.06 (13.15)*
ELI c* -0-02 (-7.70)* -0.01 (-5.23)*
El=i ck -0.05 (-0.75) 0.06 (0.49)
* Significant at the 0.10 level.

the initiation report (Reingold, 2006). Financial an

recover their research costs through commissions
If informed trading is attributed to analysts' infor
know the content and timing of the analysts' in
investors' predictability is the reason for inform
know the exact content and timing of the initiation
trading in the options market, we examine wheth
timing of analysts' initiations. Section IVC. 1 examin
of the initiations. Specifically, we review the cor
behavior and the content of analysts' reports. Sec
recognize the timing of the initiations. Specifical
metrics and the timing of the initiations.

1. Analyses According to the Content of Anal

According to Hypothesis 3, if the informed trade

dations and the target prices matter, the intensity
related to the target prices. However, before we
informativeness of target prices in our sample per

10 Although the previous literature indicates that the target p

Lehavy, 2003; Asquith et al., 2005), their findings could be pri
the sample period from 1997 to 1999. Therefore, we conduct a
in our sample period.

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Lung & Xu • Tipping and Option Trading 687

Table IV. Target Price Ratio and Abnorma

Panel A presents the analysts' target price ratio (TR) a

(AR0) for Strong Buy initiations and Buy initiations. T
B provides the regression results based on Equat
abnormal return on the announcement day for security i

Strong Buy Buy

Obs. Average Obs. Average Difference (t-stat)

Panel A. AR0 and TR for Strong Buy and Buy Initiations

AR0 736 0.60% 998 0.53% 0.07%* (6.72)

TR

Panel B. R

Coef. 0.09* 1.41*

¿-Stat 5.61 3.77

* Significant at the 0.10 level.

We conduct two analyses t

abnormal returns in our sam
Buy and Buy groups, and ex
price ratios (TR), and abno
procedure is described in t
initiations are associated wi
(2001). We also find that th
TR and AR0 between Stron
significant at less than the
Next, we use a regression m
the abnormal returns on th

AR0, i = a + ß x TRļ + £/, (16)

where ARqj is the abnormal return on the a

price ratio for security /. We expect ß to b
returns on the announcement day. Table I
positive and significant at less than the 5%
prices are positively correlated with the ab
values in our sample period.
Having established the link between analy
examine whether the intensity of abnormal t
divide the entire sample into quintiles based
cumulative AIS and ACP in each group from
presented in Panel A, for Buy Initiations, b
monotonically in the target price ratio du
average AIS increases from 0.1 1% in the lo

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 688

Table V. Target

This table presents the ave

analysts' initiations. The
while the abnormal call-to
quintiles according to the
using Buy Initiations. Pan
the difference between the
/-tests using the distributio

Day Highest High Medium Low Lowest Highest-Lowest i-Stat

Panel A. Buy Initiations
AIS
-7 0.12% 0.11% 0.08% 0.08% 0.06% 0.07% 2.63*
-6 0.29% 0.22% 0.17% 0.12% 0.07% 0.22% 8.56*
-5 0.28% 0.24% 0.20% 0.14% 0.11% 0.17% 8.03*
-4 0.31% 0.26% 0.21% 0.17% 0.13% 0.18% 8.46*
-3 0.38% 0.31% 0.23% 0.19% 0.15% 0.23% 8.32*
-2 0.40% 0.33% 0.25% 0.20% 0.16% 0.24% 8.33*
-1 0.53% 0.42% 0.34% 0.29% 0.24% 0.29% 11.54*
Cumulative AIS
-7 0.12% 0.11% 0.08% 0.08% 0.06% 0.07% 2.63*
-6 0.41% 0.33% 0.25% 0.20% 0.13% 0.28% 7.23*
-5 0.69% 0.57% 0.45% 0.34% 0.24% 0.45% 6.04*
-4 1.00% 0.83% 0.66% 0.51% 0.37% 0.63% 7.14*
-3 1.38% 1.14% 0.89% 0.70% 0.52% 0.86% 8.04*
-2 1.78% 1.47% 1.14% 0.90% 0.68% 1.10% 6.49*
-1 2.31% 1.89% 1.48% 1.19% 0.92% 1.39% 10.20*
ACP
-7 1.97 1.64 1.57 1.27 0.81 1.16 3.48*
-6 2.69 2.09 1.74 1.52 0.99 1.70 4.05*
-5 2.88 2.12 1.82 1.74 1.12 1.76 4.04*
-4 3.23 2.41 2.06 1.83 1.29 1.93 3.61*
-3 3.59 2.72 2.36 2.15 1.89 1.71 2.49*
-2 4.04 2.79 2.45 2.07 1.72 2.32 4.15*
-1 4.80 3.23 2.91 2.62 1.75 3.04 5.13*
Cumulative ACP
-7 1.97 1.64 1.57 1.27 0.81 1.16 3.48*
-6 4.66 3.73 3.31 2.79 1.80 2.86 3.95*
-5 7.54 5.85 5.13 4.53 2.92 4.62 3.35*
-4 10.77 8.26 7.19 6.36 4.21 6.56 2.73*
-3 14.36 10.98 9.55 8.51 6.10 8.26 2.07*
-2 18.40 13.77 12.00 10.58 7.82 10.58 3.71*
-1 23.20 17.00 14.91 13.20 9.57

Panel B. Sell Initiations

-7 -0.14% -0.17% -0.17% -0.20% -0.27% 0.13% ÜÜ*

-6 -0.14% -0.19% -0.23% -0.25% -0.34% 0.20% 7.43*
-5 -0.09% -0.17% -0.22% -0.27% -0.36% 0.27% 14.42*
-4 -0.15% -0.21% -0.29% -0.31% -0.40% 0.25% 11.15*
-3 -0.21% -0.25% -0.33% -0.34% -0.42% 0.21% 7.67*
-2 -0.27% -0.25% -0.36% -0.40% -0.47% 0.20% 6.15*
-1 -0.23% -0.27% -0.36% -0.41% -0.54% 0.31% 11.21*

( Continued)

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Lung & Xu • Tipping and Option Trading

Table V. Ta

Day Highest High Medium Low Lowest Highest-Lowest f-Stat

Panel B. Sell Initiations

AIS
Cumulative AIS
-7 -0.14% -0.17% -0.17% -0.20% -0.27% 0.13% 5.83*
-6 -0.28% -0.36% -0.40% -0.45% -0.61% 0.33% 6.65*
-5 -0.37% -0.53% -0.62% -0.72% -0.97% 0.60% 13.08*
-4 -0.52% -0.74% -0.91% -1.03% -1.37% 0.85% 10.59*
-3 -0.73% -0.99% -1.24% -1.37% -1.79% 1.06% 6.27*
-2 -1.00% -1.24% -1.60% -1.77% -2.26% 1.26% 4.98*
-1 -1.23% -1.51% -1.96% -2.18% -2.80% 1.57% 10.68*
ACP
-7 -1.12 -1.49 -1.52 -1.90 -2.03 0.91 3.13*
-6 -1.45 -1.73 -1.86 -2.10 -2.44 0.99 2.81*
-5 -1.70 -1.99 -2.32 -2.74 -3.10 1.40 3.72*
-4 -1.76 -1.82 -2.51 -2.62 -3.39 1.63 2.51*
-3 -1.95 -2.21 -3.05 -3.18 -3.91 1.96 2.64*
-2 -1.78 -2.16 -2.84 -3.46 -4.22 2.44 4.35*
-1 -2.40 -2.93 -3.63 -4.04 -5.51 3.11 5.52*
Cumulative ACP
-7 -1.12 -1.49 -1.52 -1.90 -2.03 0.91 3.13*
-6 -2.57 -3.22 -3.38 -4.00 -4.47 1.90 2.77*
-5 -4.27 -5.21 -5.70 -6.74 -7.57 3.30 3.34*
-4 -6.03 -7.03 -8.21 -9.36 -10.96 4.93 2.35*
-3 -7.98 -9.24 -11.26 -12.54 -14.87 6.89 2.16*
-2 -9.76 -11.40 -14.10 -16.00 -19.09 9.33 3.27*
-1 -12.16 -14.33 -17.73 -20.04 -24.60 12.44 5.04*

•Significant at the 0.10 level.

the cumulative AIS jumps from 0.24% to 0.69

quintiles is positive and significant, indicatin
content of the initiations. The results for Sell Initiations are similar. The results are consistent
with information leakage prior to the analysts' initiations, supporting Hypothesis 3.
For the Sell Initiations in Panel B, we find a similar relationship between the target price ratio
and the directional option metrics. On Day -5, for instance, the magnitude of AIS changes from
-0.36% in the lowest quintile to -0.09% in the highest quintile and the cumulative AIS changes
from - 0.97 % to -0.37%. The difference between the highest and lowest quintiles is statistically
significant. ACP follows a similar pattern. Therefore, we conclude that informed traders are privy
to the content of analysts' initiations.

2. Analysis According to the Timing of Informed Trading

To further investigate the causes of informed trading in the options market, we examine
whether informed traders are aware of the timing of the analysts' initial recommendations. If the
informed trading is attributed to analysts' information leakage, the informed investors should
know the exact timing of the initiations, and consequently, the abnormal option metrics should
cluster immediately prior to the initiations. Alternatively, if the informed trading is attributed
to savvy investors' stock-picking ability, the informed traders should not know the exact timing

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 690

of the initiations, and co

announcements.

Following Christophe et al. (2010), we compare the cumulative option metrics of th

riods to determine whether abnormal trading behavior is more intense immediately pr
initiations. We compare the cumulative AIS and ACP among three test windows: 1) im
ately prior to the initiations (Day [-1, -7]), 2) 14 trading days before the initiations
-14]), and 3) 21 trading days prior to the initiations (Day [-15, -21]). We determine w
the cumulative option metrics of Day (-1, -7) are significant and differ from those
(-8, -14) and Day (-15, -21).
The results in Table VI indicate that the abnormal option metrics cluster immediately prior
to the initiations. For Buy Initiations, the cumulative AIS for Day (-1, -7), Day (-8, -14),
and Day (-15, -21) are 1.56%, 0.02%, and -0.02%, respectively. The cumulative AIS of
Day (-1, -7) is significant and greater than that of Day (-8, -14), while the cumulative AIS
of Day (-8, -14) is not significantly different from that of Day (-15, -21). The cumulative
ACP of Day (-1, -7) is also greater than the cumulative ACP for Day (-8, - 14) and Day (-15,
-21). These findings indicate that informed investors are aware of the timing of the initiation
announcements and informed trading in the options market is attributed to analysts' information
leakage, which is consistent with the tipping hypothesis.

3. Regression Analysis

If informed investors understand the content and timing of the initiations, the degree of tipping
behavior should be related to their ex ante expectation of abnormal returns around the initiation
announcements (Irvine et al., 2007). Thus, we examine the relationship between announcement
returns and abnormal option trading activity. Specifically, we regress the abnormal return around
the event day on the cumulative option metrics from Day -7 to Day -1, controlling for price
drift. The model with AIS as the option metric is specified as

ARito = a + y x C-AISit'^i 4- ßcAR x CARi^-j

+ßMOM x MOM i -h Pf re v x FREV i, +ßsuE x SUE i -I- ßATG x ATG¡. (17)

In Equation (17), ARj^ denotes the abnormal stock return for stock i on Day 0. CARit 1.7 is the
cumulative AR for stock i from Day -7 to Day -1. C_AISit'~i is the cumulative AIS for stock
i from Day -7 to Day -1. MOM , FREV, SUE , and ATG control the firms' characteristics. If
the informed investors know the content and timing of the initiations, y should be positive and
statistically significant.
Table VII reports the test results. For Buy Initiations, we find that y is 0.2248 and significant at
less than the 5% level when we use AIS as the option metric positive. For Sell Initiations, the test
results are also significant. These results suggest that informed traders are aware of the content
and timing of the initiations and appear to be able to gauge the size of announcement returns.
Our findings support Hypothesis 3 that informed trading in the options market prior to analysts'
initiations is attributed to information leakage.

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Lung & Xu • Tipping and Option Trading 691
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 692

Table VII. Option T

The table presents the re

ARito = ot +y xC_A
xFREVi 4- ßsuE x S

where C_AISit'~i is the

abnormal stock return (A
based on Equation (6),
standardized unexpected
standard deviation over
calculated as the rolling
asset growth rate for th
market-adjusted return fo
in the /-stat columns.

Buy Initiations Sell Initiations

y 0.2248 4.16* 0.0001 2.90* 0.1524 3.55* 0.0002 5.61*

ßcAR 0.0815 1.51 0.0864 1.61 0.0673 1.71 0.1173 1.84
ßhiOM 0.0006 1.44 0.0003 0.93 0.0001 0.78 0.0003 1.45
ßFREV 0.2892 2.41* 0.2657 1.83 0.2385 2.13* 0.4921 1.41
ßsuE 0.0018 1.03 0.0039 1.52 0.0053 1.31 0.0019 0.96
&4rc*102 0.0011 1.99* 0.0003 1.73 0.0013 1.16 0.0011 1.19

* Significant at the 0.10 level.

4. Are Hedge Funds the Informed Traders in the Options Market?

We explore who traded on private information in the options market prior

initiations.11 According to the time period and the nature of the security in the stu
that hedge funds are the primary users of options to exploit their information adv
investors are generally small and uninformed. Traditional institutional investors
from financial analysts, but do not tend to use sophisticated financial products,
options (e.g., surveys by Agarwal and Naik, 2005; Brav, Jiang, and Kim, 2009).
are the primary players in the options market, firms with higher hedge fund h
more prone to the tipping hypothesis. We expect that the intensity of abnormal tr
the options market is positively related to firms' hedge fund holdings.12
We divide the sample into terciles according to hedge fund holdings obtained f
Financial. We classify the sample firms with hedge fund holdings in the top third a
those with hedge fund holdings in the bottom third as low holdings, and all other f
holdings. We reexamine the abnormal option trading behavior around the anal
using the subsamples. Table VIII demonstrates that for the Buy and Sell Initiatio
ACP ratios increase in hedge fund holdings. For instance, on Day -6, the AIS r
0. 1 8%, and 0. 1 0% for the High, Medium, and Low groups, respectively. The dif

11 We thank an anonymous referee for bringing up this crucial point.

12 We look into various option data sources, including CBOE, OPRA, and ISE. However, there is no d
trading data available. We cannot identify the specific buyers and sellers in the options market. Th
alternative method to explore hedge fund activity in the options market prior to the analysts' initiati

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 Lung & Xu • Tipping and Option Trading 693
Table VIII. Abnormal Option Trading Behavior and Hedge Fund Holdings

The table presents two option metrics, the abnormal option-implied price ratio (AIS) and the abnormal
call-to-put volume ratio (ACP), across firms with high, medium, and low hedge fund holdings. We classify
the sample firms with hedge fund holdings in the top third as high holdings, those with hedge fund holdings
in the bottom third as low holdings, and all other firms as medium holdings. The test begins 20 days before
to five days after the analysts' initiations. AIS is calculated based on Equation (10) and ACP is based on
Equation (12).

AIS ACP

Day High Medium Low Difference High Medium Low Difference

Panel A.
-20 0.03% 0.04% 0.02% 0.00% 0.15 0.21 0.18 -0.03
-19 -0.06% 0.05% -0.02% -0.04% 0.36 0.27 0.30 0.06
-18 0.02% 0.03% -0.05% 0.07% -0.25 -0.08 -0.48 0.23
-17 0.05% 0.06% -0.02% 0.07% 0.42 0.63 0.54 -0.12
-16 -0.04% -0.02% -0.03% -0.01% -0.32 -0.05 -0.71 0.38
-15 -0.03% -0.05% -0.04% 0.01% 0.26 0.78 0.94 -0.67
-14 0.06% 0.04% -0.07% 0.12% 0.36 0.55 0.29 0.07
-13 -0.07% -0.02% -0.06% -0.01% -0.25 -0.28 -0.22 -0.03
-12 -0.01% -0.03% -0.02% 0.01% -0.21 -0.06 -0.21 0.00
-11 0.06% 0.04% 0.05% 0.01% 0.18 0.11 0.13 0.05
-10 0.05% 0.04% 0.00% 0.05% 0.22 0.28 0.25 -0.03
-9 0.02% 0.03% -0.02% 0.04% 0.72 0.67 0.56 0.16
-8 -0.02% -0.01% 0.00% -0.02% 1.23 1.21 1.13 0.10
-7 0.13% 0.10% 0.04% 0.09%* 1.51* 1.47 1.37 0.14
-6 0.23%* 0.18%* 0.10% 0.13%* 1.93* 1.89* 1.61* 0.32*
-5 0.26%* 0.21%* 0.13%* 0.13%* 2.02* 1.96* 1.84* 0.18
-4 0.28%* 0.21%* 0.17%* 0.11%* 2.29* 2.17* 2.02* 0.27*
-3 0.29%* 0.25%* 0.21%* 0.08%* 2.71* 2.57* 2.34* 0.37*
-2 0.31%* 0.26%* 0.24%* 0.07% 2.88* 2.59* 2.36* 0.52*
-1 0.40%* 0.37%* 0.34%* 0.06% 3.19* 3.04* 2.95* 0.24
0 0.14%* 0.12%* 0.13%* 0.01% 3.63* 3.60* 3.54* 0.09
1 -0.07% -0.04% -0.04% -0.03% 3.05* 3.18* 3.07* -0.02
2 -0.01% -0.06% 0.01% -0.02% 2.09* 2.30* 2.18* -0.09
3 -0.06% -0.08% -0.07% 0.01% 0.56 0.53 0.59 -0.03
4 -0.04% -0.07% -0.07% 0.03% -0.11 -0.08 -0.11 0.00
5 -0.04% -0.06% -0.02% -0.02% 0.76 0.71 0.84 -0.08

( Continued)

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 694

Table VIII. Abnorm

(Continued)
Day High Medium Low Difference High Medium Low Difference
(High-Low) (High-Low)
Panel B. Sell Initiations

-20 0.06% 0.04% 0.05% 0.01% -0.55 -0.61 -0.64 0.09

-19 -0.02% -0.01% -0.03% 0.01% 0.61 0.55 0.40 0.21
-18 0.04% 0.05% -0.03% 0.07% -0.80 -0.67 -0.66 -0.14
-17 -0.03% 0.02% -0.02% -0.01% -0.71 -0.89 -0.86 0.15
-16 0.03% 0.06% 0.03% 0.00% 0.88 0.73 0.85 0.03
-15 -0.03% 0.01% -0.07% 0.04% 0.31 0.44 0.39 -0.08
-14 -0.01% -0.02% 0.00% -0.01% -1.01 -0.97 -0.93 -0.08
-13 0.02% 0.05% 0.05% -0.03% 0.68 0.77 0.83 -0.15
-12 0.07% 0.07% 0.04% 0.03% 0.70 0.91 0.88 -0.18
-11 -0.04% -0.06% -0.02% -0.02% -0.06 -0.11 -0.10 0.04
-10 0.03% 0.01% 0.08% -0.05% 0.62 0.77 0.86 -0.24
-9 -0.11% -0.08% -0.02% -0.09% -0.77 -0.71 -0.56 -0.21
-8 -0.16% -0.11% -0.09% -0.07% -1.69* -1.52 -1.02 -0.67*
-7 -0.21%* -0.18% -0.18% -0.03% -1.82* -1.57 -1.44 -0.38*
-6 -0.27%* -0.23%* -0.19% -0.08% -2.09* -1.88* -1.79* -0.30*
-5 -0.30%* -0.23%* -0.13% -0.17%* -2.56* -2.41* -2.14* -0.42*
-4 -0.32%* -0.27%* -0.22%* -0.10% -2.71* -2.43* -2.12* -0.59*
-3 -0.35%* -0.33%* -0.25%* -0.10% -3.06* -2.91* -2.61* -0.45*
-2 -0.39%* -0.37%* -0.29%* -0.10% -3.17* -2.95* -2.55* -0.62*
-1 -0.41%* -0.38%* -0.29%* -0.12%* -3.88* -3.80* -3.42* -0.46*
0 -0.29%* -0.30%* -0.28%* -0.01% -3.94* -3.93* -3.93* -0.01
1 -0.19% -0.23%* -0.21% 0.02% -3.09* -3.22* -3.17* 0.08
2 0.04% 0.07% 0.04% 0.00% -2.51* -2.74* -2.61* 0.10
3 -0.05% -0.05% -0.02% -0.03% -0.97 -1.21 -1.09 0.12
4 0.04% 0.05% 0.00% 0.04% -1.29 -1.18 -1.25 -0.04
5 -0.03% -0.05% 0.02% -0.05% -0.31 -0.21 -0.26 -0.05

* Significant at the 0.10 level.

the High and Low groups is 0.13% and significant at

relation between the hedge fund holdings and our opt
likely to be the primary players in the options mark
caution in interpreting the empirical results presente
may receive tips on stocks that they do not own. Our
of tipping. This study does not directly answer when
information. We leave it for future research to investig

D. Economic Incentives

With the evidence of informed trading in the options market prior to analysts' in
we examine the economic incentives for exploiting private information in the options
We design a trading simulation to demonstrate the economically significant trading pro
options market. For Buy Initiations, we consider the trading return from buying call optio

13 We thank an anonymous referee for bringing up this critical point.

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Lung & Xu • Tipping and Option Trading 695
Table IX. Trading Profits Around Analys

This table presents the profits of trading stocks and options ar

we compare the trading profits from buying call option versus b
the trading profits of buying put option and shorting stocks. S
close the position. The {-statistics are reported in the r-stat col

Buy Initiations Sell Initiations

Trade Square Call Stock Difference Put Stock Difference

Day Day Profit (%) Profit (%) (%) f-Stat Profit (%) Profit (%) (%) (-Stat
Panel A. Option Trading Profits Based on the Options with the Highest Leverage Effect
-7 0 4.47 1.10 3.37 3.25* 5.09 1.22 3.87 4.53*
-6 0 4.36 1.08 3.28 3.51* 5.02 1.20 3.82 4.96*
-5 0 4.19 1.04 3.15 3.60* 4.92 1.19 3.73 5.60*
-4 0 3.85 1.02 2.83 3.89* 4.78 1.15 3.63 4.32*
-3 0 3.51 0.91 2.60 3.13* 4.50 1.12 3.38 3.47*
-2 0 3.18 0.84 2.34 4.25* 3.62 0.96 2.66 3.20*
-1 0 1.92 0.78 1.14 2.62* 2.42 0.88 1.54 2.64*
-7 1 5.08 1.35 3.73 3.56*
3.52* 5.74 1.61 4.13
-6 1 4.94 1.26 3.68 5.89* 5.58 1.56 4.02 5.46*
-5 1 4.85 1.21 3.64 4.07* 5.37 1.46 3.91 4.85*
-4 1 4.59 1.20 3.39 4.39* 5.18 1.38 3.81 4.79*
-3 1 4.34 1.16 3.18 3.61* 4.97 1.34 3.63 3.28*
-2 1 4.15 1.05 3.10 3.43* 4.82 1.26 3.56 4.50*
-1 1 3.17 0.92 2.25 4.68* 3.85 1.15 2.70 3.56*
-7 2 5.55 1.76 3.79 3.44* 7.13 2.42 4.71 3.61*
-6 2 5.46 1.91 3.56 4.13* 7.02 2.38 4.64 4.84*
-5 2 5.18 1.68 3.50 8.77* 6.80 2.20 4.60 4.34*
-4 2 5.06 1.87 3.19 6.94* 6.48 2.02 4.47 3.46*
-3 2 4.78 1.62 3.16 8.12* 6.30 1.95 4.35 3.53*
-2 2 4.62 1.52 3.11 4.72* 6.18 1.87 4.31 3.76*
-1 2 3.86 1.35 2.51 4.72* 4.83 1.69 3.14 4.91*

Panel B. Option Trading Profits Based on the O

-7 0 4.13 1.10 3.03 2.81* 4.51 1.22 3.29 3.56*
-6 0 4.25 1.08 3.17 3.06* 4.47 1.20 3.27 4.04*
-5 0 3.82 1.04 2.78 3.01* 4.75 1.19 3.56 5.09*
-4 0 3.47 1.02 2.45 3.33* 4.36 1.15 3.21 3.59*
-3 0 3.14 0.91 2.23 2.44* 4.50 1.12 3.38 3.39*
-2 0 2.71 0.84 1.87 3.26* 2.99 0.96 2.03 2.22*
-1 0 1.79 0.78 1.01 2.27* 1.96 0.88 1.08 1.68
-7 1 4.70 1.35 3.35 3.13* 5.19 1.61 3.58 2.91*
-6 1 4.58 1.26 3.32 5.14* 4.88 1.56 3.32 4.24*
-5 1 3.90 1.21 2.69 2.78* 4.93 1.46 3.47 4.04*
-4 1 3.79 1.20 2.59 3.15* 4.76 1.38 3.38 3.94*
-3 1 4.01 1.16 2.85 3.03* 4.61 1.34 3.27 2.89*
-2 1 3.51 1.05 2.46 2.46* 3.95 1.26 2.69 3.12*
-1 1 2.69 0.92 1.77 3.54* 3.21 1.15 2.06 2.48*
-7 2 5.01 1.76 3.25 2.81* 6.03 2.42 3.61 2.70*
-6 2 4.90 1.91 2.99 3.35* 5.81 2.38 3.43 3.47*

( Continued)

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696

Table IX. Trading P

Buy Initiations Sell Initiations

Trade Square Call Stock Difference Put Stock Difference

Day Day Profit (%) Profit (%) (%) f-Stat Profit (%) Profit (%) (%) f-Stat
-5 2 4.41 1.68 2.73 6.58* 5.29 2.20 3.09 2.79*
-4 2 4.19 1.87 2.32 5.04* 4.88 2.02 2.86 2.11*
-3 2 4.15 1.62 2.53 5.92* 4.67 1.95 2.72 2.10*
-2 2 4.03 1.52 2.51 3.59* 4.29 1.87 2.42 2.06*
-1 2 3.18 1.35 1.83 3.31* 3.58 1.69 1.89 1.77

Panel C. Option Trading Profits Based on

-7 0 2.71 1.10 1.61 1.15 3.16 1.22 1.94 1.73
-6 0 2.87 1.08 1.79 1.44 2.89 1.20 1.69 1.44
-5 0 2.65 1.04 1.61 1.46 3.51 1.19 2.32 2.16*
-4 0 2.68 1.02 1.66 1.84 3.23 1.15 2.08 1.77
-3 0 2.29 0.91 1.38 1.25 3.30 1.12 2.18 1.72
-2 0 2.04 0.84 1.20 1.73 2.31 0.96 1.35 1.26
-1 0 1.14 0.78 0.36 0.66 1.46 0.88 0.58 0.78
-7 1 3.47 1.35 2.12 1.62 4.06 1.61 2.45 1.65
-6 1 3.29 1.26 2.03 2.39* 3.87 1.56 2.31 2.43*
-5 1 2.81 1.21 1.60 1.51 3.40 1.46 1.94 1.91
-4 1 2.60 1.20 1.40 1.36 3.75 1.38 2.37 2.21*
-3 1 3.16 1.16 2.00 1.80 3.36 1.34 2.02 1.38
-2 1 2.69 1.05 1.64 1.43 3.04 1.26 1.78 1.76
-1 1 1.74 0.92 0.82 1.26 2.86 1.15 1.71 1.70
-7 2 3.81 1.76 2.05 1.43 4.93 2.42 2.51 1.38
-6 2 3.82 1.91 1.91 1.71 4.75 2.38 2.37 2.06*
-5 2 3.11 1.68 1.43 2.59* 3.86 2.20 1.66 1.23
-4 2 3.25 1.87 1.38 2.53* 4.04 2.02 2.02 1.13
-3 2 2.82 1.62 1.20 2.18* 4.63 1.95 2.68 1.73
-2 2 2.85 1.52 1.33 1.64 3.67 1.87 1.80 1.30
-1 2 2.38 1.35 1.03 1.61 2.71 1.69 1.02 1.17

'Significant at the 0. 10 level.

buying stock. For Sell Initiations, the investors

equity. In all instances, the returns are the ne
the bid-ask spread.14
In the simulation, we examine three scenar
informed investors' potential trading profit
expect that informed investors use the option
private information and maximize their profit
the highest delta to price ratio at 4:00 p.m.
based on the options with the lowest bid-ask
by bid-ask spreads. The bid-ask spread ratio
midpoint of the option quotes. In the final sc
available in our sample. We estimate the option

14 The transaction cost is $0.01 per stock share plus the

leading online trading firm, TradeStation.com.

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Lung & Xu » Tipping and Option Trading

quotes at 4:00 p.m. (EST) and the

option price at 4:00 p.m. (EST) as
average bid-ask spread ratio.
We consider the informed trad
subsequently closing out the tr
trader may buy a call option on
trading days (from Day -7 to D
21 (7x3) possible trading combin
pairs of trades in Table IX.
Panel A presents the test result
that trading options are more p
differences between the option
For instance, the average retur
and sell them on Day 0, while i
prior to the Buy Initiations. Th
The difference in trading prof
at Day 0) to 4.71% (buy put o
that informed s traders can earn
analysts' initiations and, as such
results confirm our aforementio
Panel B presents the test result
findings are consistent with thos
of trades, the option trading pr
suggests that when informed in
on trading profits than the bid-
Finally, Panel C exhibits the tr
We find that the profits from tr
B. Although, in general, the opt
significant in most of the case
off if they consider the option
information.

V. Conclusion

We examine the options market behavior around analysts' initiations. This study co
research strands: 1) information leakage prior to analysts' initiations and 2) inform
in the options market. Consistent with the tipping hypothesis in the literature, our
indicate that the options market reveals private information seven days before financ
publicly announce their initial recommendations. Informed investors know not only
but also the content of these initial recommendations.
We find significant information flow from the options market to the stock market pr
lysts' initiations indicating that the options market represents the preferred habitat for
investors. Furthermore, this study confirms that informed trading is attributed to analy
mation leakage instead of savvy investors' predictability. We also find evidence that h
are the primary players in the options market prior to analysts' initiations. Finally, in
trading based on the ex-post transaction cost and bid-ask spread, we demonstrate t
options on private information is more profitable than trading stocks.

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698

Our study concludes tha

options market and tho
involvement of insider tr
involving the options m
aggressive steps to detect
findings prompt the regu
market.

Appendix

The Procedure to Sta

The Appendix describes

initial
reports from Brief
their recommendations,
Sell Initiations according

Recommendation Term Classification

NTLTStrongBuy Buy Strong
NTStrongBuy Strong Buy
NTStrongBuyLTStrongBuy Strong Buy
STBuyLTBuy Strong Buy
StrongBuyAggress Strong Buy
StrongBuySpec Strong Buy
STBuy Strong Buy
NTLTOutperformer Buy
NTMktOutperformer Buy
NTMktPrfhiLTOutprfm Buy
NTNeutLTBuy Buy
NTOutperform Buy
Outerperform Buy
OutperformBuy Buy
OverWeight Buy
RecommendedList Buy
RecommList Buy
SectorOutperformer Buy
SpeculativeBuy Buy
ThematicOpportunity Buy
TradingBuy Buy
NTUnderperfLTPerf Sell
SectorUnderperformer Sell
STAvoid Sell
STAvoidLTAvoid Sell
Unattractive Sell
Underweight Sell
SellShort Sell
Short Sell
StrongSell Sell

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Lung & Xu • Tipping and Option Trading 699
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