Option Market Efficiency and Analyst Recommendations

Abstract

This paper examines the information content in option markets surrounding analyst recommendation changes. The sample includes 6,119 recommendation changes for optionable stocks over the period January 1996 through December 2005. As expected, mean underlying asset returns are positive (negative) on days of recommendation upgrades (downgrades). However, volatility levels and shifts prior to recommendation changes explain a significant portion of underlying asset price responses. Ex-ante price and volatility responses in option markets are linked to increased jump uncertainty risk premia. Our findings suggest information in option markets leads analyst recommendation changes, implying revisions contain less information than previously thought. Copyright (c) 2010 Blackwell Publishing Ltd.

Discussion of Option Prices Leading Equity Prices: Do Option Traders Have an Information Advantage

“…The preevent return predictability is consistent with many existing studies finding that option characteristics predict stock returns in general (Pan and Poteshman [2006], Cremers and Weinbaum [2010], Xing, Zhang, and Zhao [2010], Johnson and So [2011]) as well as before major events such as earnings announcements (Amin and Lee [1997]), takeover announcements (Cao, Chen, and Griffin [2005]), and analyst recommendations (Doran, Fodor, and Krieger [2010]), so the results themselves are not surprising.…”

Informational content of options around analyst recommendations

“…To alleviate the confounding effect of other corporate announcements, we further exclude recommendation changes that occur within the [-1, +1] days, earnings event window (Loh and Stulz, 2011). 6 Finally, we follow Doran et al (2010) and (i) remove conflicting recommendation changes made by multiple analysts on the same day, and (ii) treat identical recommendation changes made by multiple analysts on the same day as a single revision.…”

Discovering a Profitable Trading Strategy in an Apparently Efficient Market: Exploiting the Actions of Less Informed Traders in Speculative Markets

“…Firms can, thus, make appropriate production-investment decisions and investors can regulate capital flows by making informed choices between stocks, leading to capital being 'invested in projects expected to be value creating and withdrawn from projects with poor prospects' (Bushman et al, 2011). It is not surprising, therefore, that there is an extensive literature examining the degree to which capital market participants effectively employ a variety of information to inform their investment decisions (e.g., trading volume: Bajo, 2010; analysts' recommendations and forecasts: Brown and Pfeiffer, 2008;and Doran et al, 2010; increases in R&D spending: Ali et al, 2012; financial statement information: Xue and Zhang, 2011;and Skogsvik, 2008; the proportion of informed and less informed investors, Brusa et al, 2005). Several anomalies have been observed but there is still strong support for the EMH (e.g., Fama, 2010).…”