Journal of Financial and Strategic Decisions Volume 12 Number 1 Spring 1999

Journal of Financial and Sraegic Decisions Volume 12 Number 1 Spring 1999 THE LEAD-LAG RELATIONSHIP BETWEEN THE OPTION AND STOCK MARKETS PRIOR TO SUBSTANTIAL EARNINGS SURPRISES AND THE EFFECT OF SECURITIES REGULATION C. Michell Conover * and David R. Peerson ** Absrac This sudy invesigaes he lead-lag relaionship beween he opion and sock markes for 17 rading-days prior o subsanial earnings surprises, using he Berkeley opions daa base, changes in pu-call pariy, and a conrol opion mehodology. Before he passage of he Insider Trading Sancions Ac (ITSA) in 1984, he opions marke leads he sock marke prior o negaive surprises bu ha he sock marke leads prior o posiive surprises. Afer he passage of ITSA here is no leading role for eiher marke under posiive or negaive surprises. These resuls may sugges imporan roles for insiuional facors, such as shor sale consrains, and he inensiy of securiies regulaion. INTRODUCTION Several sudies find informed rading in equiy markes by insiders and ohers prior o earnings announcemens. Meulbroek [16] repors run-ups in sock prices ha are almos half ha of announcemen day abnormal reurns. Ellio, Morse, and Richardson [9] find ha insiders boh increase heir purchases and decrease heir sales of sock prior o he announcemen of large earnings increases. Finally, Affleck-Graves, Jennings and Mendenhall [1] find informed rading over a six-week period preceding earnings surprises. The above sudies focus on informed rading in he sock marke. However, here are many reasons why informed raders would prefer he opions marke o he sock marke. Firs, opions may provide a greaer leverage posiion in he underlying sock. Second, Cox and Rubinsein [7] argue ha since insiuional invesors se prices in he opions marke, he ineres raes implici in opion prices are more favorable han individual invesors could obain on heir own. Third, ransacions coss for rading in opions are ofen lower. Fourh, for hose who wish o ake a shor posiion, he opions marke offers furher advanages. There is no upick rule in he opions marke as here is for shor sales in he sock marke and losses in a shor posiion can be limied wih he purchase of pu opions, whereas he loss from shoring socks is poenially unlimied. Addiionally, many insiuions are resriced from shor sales bu no opion posiions. If informed raders prefer he opions marke, he value of privae informaion should be impounded ino opions prices before sock prices. Evidence of opion prices or volume leading sock prices or volume is found by Manaser and Rendleman [15], Bhaacharya [5], Anhony [3], and Finucane [12]. Sephan and Whaley [19] find ha he sock marke leads he opion marke, bu Chan, Chung, and Johnson [6] show his resul is due o wider percenage ick moves and bid-ask spreads in he opions marke, leading o nonsychronous rading. Generally, however, hese sudies do no explicily es he lead-lag relaionship in specific cases where some raders may have privae informaion. I is in hese insances when he moivaions o rade firs in he opions marke should be he sronges. A few researchers have invesigaed he lead-lag relaionship prior o he release of valuable informaion. For example, Sephan and Whaley [19] proxy for he arrival of informaion by examining socks wih large changes in price on a given day and conclude ha he sock marke leads he opions marke. However, heir es does no deermine he cause of he sock price change. Many influences on sock prices are hose which few raders would have knowledge of beforehand. Thus, heir mehodology does no acually es for he presence of informed rading prior o informaional announcemens. Also, hey only examine he lead-lag relaionship he day of he price change. *Norhern Illinois Universiy **Florida Sae Universiy 41

42 Journal of Financial and Sraegic Decisions Amin and Lee [2] examine opion rading before earnings announcemens. They find abnormally high opion volume up o four days before he announcemen and abnormal opion reurns up o 30 rades prior o he announcemen. However, equiy reurns are also abnormal preceding he announcemen and, hus, i is no clear if one marke is leading he oher. If earnings announcemens were resriced o large surprises, raher han using all announcemens, hen anicipaory price paerns may have been clearer. Lasly, opion and sock prices are examined only immediaely around he announcemen (50 rades preceding he announcemen). Informed raders may ake posiions much sooner. Despie he inheren and legal advanages ha opions offer informed raders and despie he overwhelming evidence ha informed rading occurs prior o informaional announcemens, here is a lack of evidence as o wheher informed raders use he opions marke resuling in he opions marke leading he sock marke prior o informaional evens. The purpose of his sudy is o deermine wheher he opions marke leads he sock marke prior o earnings surprises. Raher han examining a few hours or rades before he earnings release, as in prior research, pricing relaionships are analyzed over a seveneen rading-day period preceding he announcemen dae. Unlike previous sudies of informed rading before earnings announcemens, his sudy only examines announcemens ha elici a significan sock price response. Addiionally, he relaionship beween he opions and sock marke is assessed using pu-call pariy, which does no depend on he validiy of an opion pricing model or he calculaion of implied volailiies. This paper also deermines if any lead relaionship is asymmeric wih respec o he ype of he news. Iniial opions posiions underaken by informed raders should be larger for bad news since he opions marke offers unique advanages for shor posiions which are no available in he sock marke. Wih he availabiliy of opions, sock prices should adjus more quickly o negaive informaion as his informaion is impounded more efficienly due o he advanages of opions wih respec o shor posiions. Damodaran and Lim [8] find ha he lising of pu opions resuls in a faser speed of reacion o bad news earnings announcemens and greaer anicipaion of hem. Figlewski and Webb [11] find ha socks wih lised opions do no experience he same degree of fuure underperformance as do firms wihou opions when shor sales are high. This implies ha opions provide unique opporuniies for raders wishing o rade on negaive informaion. Thus, he exen o which he opions marke leads he sock marke should be heighened prior o he release of unfavorable earnings announcemens. Whereas prior sudies find ha he presence of opions improves informaional efficiency wih respec o bad news, none explicily es wheher i is a leading opions marke ha causes his asymmery. Las, his paper examines wheher changes in he regulaory environmen have affeced he lead-lag relaionship beween he opions and sock marke. The Insider Trading Sancions Ac of 1984 (ITSA) increased he penalies for insider rading in general and opions rading in specific. Prior o he passage of ITSA here was doub as o wheher insider rading laws perained o opions and wheher opions raders could be prosecued under insider rading laws since hey are rading in a derivaive securiy no held by sockholders and, hus, here is a lack of fiduciary duy o shareholders. However, Congress closed his loophole wih he passage of ITSA ha made opion raders liable o sockholders so ha inside rading in he opions marke was illegal. This law may have had a significan impac on informed rading prior o earnings announcemens, and miigaed a poenial leading role for he opions marke. Seyhun [18] finds ha corporae insiders are more relucan o rade in equiy markes prior o earnings announcemens afer he passage of ITSA. However, no one has examined he impac of ITSA on informed rading in he opions marke. The resoluion of his issue has imporan implicaions for he effeciveness of securiy regulaion and is proper emphasis, and increases our undersanding of he opions marke as i has developed hrough ime. This sudy is developed as follows. The nex secion describes he daa and mehodology. Empirical resuls are provided in he following secion. The las secion presens a conclusion. Daa DATA AND METHODOLOGY The resored form of he Berkeley Opions Daa Base is employed o idenify all firms wih lisings on he Chicago Board Opions Exchange (CBOE) of a leas hree monhs during he period January 1983 hrough November 1988. I also provides call, pu, and sock price quoaions. Sandard and Poor s Compusa daabase is used o obain quarerly earnings announcemen daes. The earnings announcemen daes for firms no covered by Compusa are obained from he Wall Sree Journal Index. For each earnings announcemen a hree-day window surrounding he Compusa or Wall Sree Journal announcemen dae is used o search for he day wih he larges marke-adjused sock price response, using he Universiy of Chicago s Cener for Research in Securiy Prices (CRSP) daa base. This day is defined as he announcemen dae, or day ED=0.

The Lead-Lag Relaionship Beween The Opion And Sock Markes 43 The sample of earnings announcemens is hen reduced o eliminae hose ha are no subsanial enough o produce a large sock price response. Previous sudies rely on earnings models o deermine he informaional imporance of announcemens. However, his sudy examines only hose announcemens ha acually resul in a subsanial sock price movemen since i is for hese announcemens ha informed raders should have he greaes incenive o rade. Those announcemens eliciing a marke-adjused reurn on ED=0 greaer han zero are referred o as posiive news announcemens and hose eliciing a marke-adjused reurn on ED=0 less han zero are referred o as negaive news announcemens. The posiive and negaive earnings announcemens are each sored in order of marke-adjused reurn. The op 25 percen of posiive earnings announcemens and he lower 25 percen of negaive earnings announcemens are seleced. The daa is divided by subperiods o analyze he effec of securiy regulaions on he lead-lag relaionship in he opions and sock markes. ITSA was passed on Augus 10, 1984. Since he ess o follow examine informed rading over almos a monh before an earnings announcemen, he second subsample of earning announcemens begins a monh afer he passage of he law. Thus, he pos-itsa sample period does no begin unil Sepember 10, 1984. The ending dae for he firs subsample is he day ha ITSA was passed. Therefore, he pre-itsa subperiod is from February 1, 1983, hrough Augus 10, 1984, and he pos-itsa subperiod is from Sepember 10, 1984, hrough November 19, 1988. These subsamples of earnings announcemens are used in subsequen ess o ascerain he effeciveness of securiies regulaion. In his sudy, day ED=0 is defined as he probable firs public release of he earnings announcemen. Using a SEC daabase of prosecued insider rading cases, Meulbroek [16] finds ha he average insider rading inciden akes place 13.2 days before he informaion is made public. Paell and Wolfson [17] find subsanial increases in implied volailiies in he opions marke beginning approximaely seveneen rading-days prior o quarerly earnings announcemens. Using hese sudies as a guide for he esimaion inerval, he invesigaion of he lead-lag relaionship begins a day ED=-17, wih quoes during days ED=-20 o ED=-18 forming a benchmark period. The sudy ends a day ED=-1, he day before public release of he earnings announcemen. The calculaion of pu-call pariy relaionships requires concurren prices of pus, calls, and he underlying sock. The Berkeley daa base is firs searched for pu quoes and hen hese are mached wih he chronologically neares call quoes, occurring wihin fifeen minues of he pu quoe, ha have he same underlying sock price. Bid and ask quoes are used insead of ransacion prices because hey allow a more accurae characerizaion of he relaionship beween sock and opions. Togeher wih he accompanying sock price, he paired pu and call quoes provide he securiy price informaion needed o calculae pu-call pariy measures. For each firm one pu-call pair is chosen ha has a common mauriy and exercise price and his same pair is used hroughou he esimaion period o ensure consisency of pu-call pariy measuremens. The analysis uses he mos acively raded pu-call pair for each firm. The sample of sock and opion prices are also srucured o ensure ha boh markes are rading a he same ime. Before Sepember 30, 1985, he opions marke opened a 9:00 Cenral Sandard Time (CST) while he sock marke opened a 8:30 CST. Though boh markes now open a 8:30 CST, opions do no sar rading unil he underlying sock has already raded. Since he opening of he opions marke is delayed relaive o he sock marke, we eliminae he firs sock price and opion bid and ask quoe of each rading day. Also, because he sock marke closes a 3:00 CST, he sample of opions prices is resriced o hose before 3:00 CST, as in Sephan and Whaley [19]. In he model of Kyle and Villa [14], informed raders may wish o conceal heir aciviy in securiies markes by ransacing wih noise raders. In he case of opions, mos noise rading will ake place in he mos hickly raded opions. Thus, in addiion o choosing he mos hickly raded opions for each firm, he analysis is repeaed for a subsample of earnings announcemens wih accompanying high opions volume. The larger sample is pariioned o include only he op half of posiive and op half of negaive earnings announcemens where he pariion is based on he volume of opions raded. The final sample consiss of 511 announcemens. The number of announcemens in each subperiod and for boh posiive and negaive news is shown in Table 1. The sample is spli fairly evenly beween posiive and negaive news announcemens wih slighly more posiive announcemens. Table 1 also provides summary saisics for he announcemen dae marke-adjused reurns of each subsample. All have a mean marke-adjused reurn near 0.05 in absolue value, wih a sandard deviaion close o 0.02. These earnings announcemens provide considerable incenive for an informed rader o ac before he firs public release and hence are of economic significance.

44 Journal of Financial and Sraegic Decisions TABLE 1 Number of Quarerly Earnings Announcemens and Saisics for Marke-Adjused Reurns by Sub-period and Type of Announcemen The following quarerly earnings announcemens are for CBOE firms during he period February 1983 unil November 1988. Announcemens eliciing an announcemen day marke-adjused reurn greaer han zero are referred o as posiive news while hose eliciing a marke-adjused reurn less han zero are referred o as negaive news. The pre- ITSA period is measured from February 1, 1983, o Augus 10, 1984. The pos-itsa period is from Sepember 10, 1984, o November 19, 1988. Sub-period and Type of Announcemen Number of Earnings Announcemens (Number of Firms) Mean Marke- Adjused Reurn (Sandard Deviaion) Maximum Marke- Adjused Reurn in Absolue Value Minimum Marke- Adjused Reurn in Absolue Value Pre-ITSA Posiive News Pre-ITSA Negaive News Pos-ITSA Posiive News Pos-ITSA Negaive News Toal Number of Earnings Announcemens (Firms) 90 (29) 82 (63) 181 (51) 158 (94) 511 (146) 0.0529 (0.0252) -0.0545 (0.0282) 0.0514 0.0203-0.0497 (0.0184) 0.225 0.035 0.200 0.032 0.190 0.035 0.119 0.032 Mehodology An exac pu-call pariy relaionship for American opions canno be derived as for European opions, since, in he presence of dividends, boh American pus and calls may be opimally exercised early. However, in he absence of marke fricions and wih known ineres raes and known dividend amouns paid wice over he life of he opion, upper bounds (UB) and lower bounds (LB) can be derived for he sock price, as in Jarrow and Rudd [13]: Equaion 1 UB a b = C P + d B(, T ) + d B(, T ) + K S 1 1 2 2 Equaion 2 LB = C b a P + L S where L is he minimum of: [KB(,T) + d l B(,T l ) + d 2 B(,T 2 )], [KB(,T 2 ) + d l B(,T l )], [KB(,T l )]. In equaions (1) and (2), C and P denoe call and pu opion quoes and he superscrips denoe he bid and ask. The curren ime is while T i is he ime ha dividends, d i, are paid, and T is he ime of opion expiraion. K is he exercise price, S is he sock price, and B(,T i ) is he price a ime of a defaul risk free, zero coupon bond paying $1 a mauriy of ime i=1,2. B(,T) is he price a ime of a defaul risk free, zero coupon bond paying $1 a expiraion of he opion.

The Lead-Lag Relaionship Beween The Opion And Sock Markes 45 If call opion prices become more underpriced (overpriced) relaive o socks hen he deviaion of he sock price from is lower (upper) boundary will widen and he deviaion of he sock price from is upper (lower) boundary will narrow. Similarly, if pu opion prices become more underpriced (overpriced) relaive o socks hen he deviaion of he sock price from is lower (upper) boundary will narrow and he deviaion of he sock price from is upper (lower) boundary will widen. Prior o posiive earnings announcemens, informed raders would mos likely ake a long posiion in he sock or is call opions, or hey would sell pu opions. Thus i is expeced ha sock and call opion prices should rise and pu prices fall. In he presence of rading in he opions marke ha precedes rading in he sock marke, here should be upward pressure on call prices and downward pressure on pu prices. In his case, he deviaion of he sock price from is lower boundary should narrow as he lower boundary moves closer o he sock price and he deviaion from he upper boundary should widen as he upper boundary moves away from he sock price. If, insead, he sock marke leads he opions marke prior o earnings announcemens, here should be upward pressure on sock prices prior o he announcemens. In his case, he deviaion of he sock price from is lower boundary should widen and he disance from he upper boundary should narrow. Prior o negaive earnings announcemens, informed raders would mos likely ake a shor posiion in he sock or wrie call opions, or hey would buy pu opions. Sock and call opion prices should decrease and pu prices should rise. In he presence of rading in he opions marke ha precedes ha in he sock marke, here should be downward pressure on call prices and upward pressure on pu prices. In he case of bad news, he deviaion of he sock price from is lower boundary should widen as he lower boundary falls below he sock price and he disance beween he sock price and upper boundary should narrow as he upper boundary drops closer o he sock price. If, insead, he sock marke leads he opions marke prior o earnings announcemens, here should be downward pressure on sock prices beforehand. In his case, he deviaion of he sock price from is lower boundary should narrow and he deviaion of he sock price from is upper boundary should widen. The following saisic is defined o evaluae he relaionship beween opion and sock prices in he period preceding earnings announcemens: Equaion 3 S LB D = UB LB D is a measure of deviaion from pu call pariy ha is scaled by he difference in upper and lower bounds for an opion. Scaling by he upper and lower boundaries conrols for differences in D due o differences in opion bid-ask spreads across firms. D should decrease (increase) in he preannouncemen period for posiive (negaive) earnings announcemens if he opions marke leads he sock marke. If, on he oher hand, he sock marke leads he opions marke, D should increase (decrease) in he preannouncemen period for posiive (negaive) announcemens. Alhough a lead-lag relaionship may exis beween he sock and opion markes, i is no possible o hypohesize he duraion of changes in pu-call pariy boundaries. The duraion of such changes depends on he informaiveness of securiy price movemens and he presence of marke fricions ha would preven marke observers from acing on such movemens. If capial markes are perfec, hen a lead for eiher he sock marke or opions marke would quickly vanish wihin seconds. In his case, D would remain consan during days ED=-20 o ED=0. If, however, marke fricions are presen, he adjusmen process beween he wo markes migh be somewha slower. In his case, D would change a some ime during days ED=-20 o ED=0 wih an evenual reurn o is previous value. The mehodology does no sugges ha pu-call pariy boundaries are violaed. Raher, he goal is o deermine if here has been some movemen wihin he boundaries due o he presence of informed rading. Because of marke fricions, i is expeced ha movemens in he boundaries implied by pu-call pariy endure long enough o be deeced such ha he informaiveness of boundary movemens will no be immediaely impounded ino he lagging marke s prices. Since he informaiveness of poenial unusual rading in he opions marke is likely o be evenually impounded ino sock prices, changes in pu-call boundaries should be measured over an inerval shor enough o deec he presence of such changes. However, he inerval chosen mus also conain a leas one pu and call quoe o calculae pu-call pariy. Half-day inervals are used o saisfy boh consrains. D is firs calculaed for each earnings announcemen for days ED=-20 o ED=-18 o form a benchmark saisic. During his benchmark period, D is calculaed for each earnings announcemen for all quoes on he chosen pair of opions in he hree rading-day period. All he D s during his hree-day period are hen averaged o form he benchmark saisic for each announcemen, referred o as D b. Days ED=-17 o ED=-1 are hen divided ino half-day inervals and a represenaive D is calculaed for each halfday inerval for each earning announcemen using all opion bid and ask quoes for he same chosen pair in he inerval.

46 Journal of Financial and Sraegic Decisions If only one pu-call pair is available in an inerval, hen ha pair is used o form he represenaive D for ha inerval. If more han one pair is available, hen all pairs are used o form an equally-weighed average D and his average D is used as he represenaive D for an earnings announcemen firm during an inerval. The separaion of rading days ino halves uses noon as he division beween he wo inervals. Because he passage of ime is known o decrease he value of boh pu and call opions, he value of D may change over ime even in he absence of informed rading. Hence, D is also calculaed for an opion conrol firm over he benchmark period (days ED=-20 o ED=-18) and for each of he inervals during he even period (days ED=-17 o ED=-1). In each ime period, he D for his conrol firm is subraced from he D of he firm wih an upcoming earnings announcemen o arrive a saisics ha should be free of passage of ime effecs. Four conrol firms are seleced for use so ha each of he hree possible calendar rading cycles ha CBOE opions rade on are represened by a leas one conrol firm. The January, April, July, and Ocober cycle is represened by IBM opions. The February, May, Augus, and November cycle is represened by Hewle Packard opions and he las rading cycle is represened by General Moors opions in 1983-1986 and General Elecric opions in 1987 and 1988. These four conrol firms are chosen because hey were very acively raded, minimizing sample ariion for any half-day inerval. The paricular pu and call conrol opions seleced for each earnings announcemen firm mus have he same mauriy dae as he announcemen firm s opions and a raio of he exercise price o sock price as close as possible in absolue value o ha of he announcemen firm. As for earnings announcemen firms, he same pu and call pair is reained over he enire esimaion period of days ED=-20 o ED=-1 for he conrol firm. Once a suiable conrol se of pu and call opions are idenified, a represenaive D is calculaed for each conrol firm using an equally-weighed average of all D s on he chosen pair of opions during he benchmark esimaion period of days ED=-20 o ED=-18. The D for hese firms opions is hen calculaed for each of he half-day inervals during days ED=-17 o ED=-1 using all opion bid and ask quoes for he same chosen pair in he inerval. As for he earning announcemen firm opions, if only one pu-call pair quoe is available in an inerval, hen his quoe is used as he represenaive D for a conrol firm during ha inerval. If more han one pair is available, hen all pairs are used o form an equally-weighed average D and his average D is used as he represenaive D for a conrol firm during an inerval. The conrol firm D is hen subraced from he D of each earnings announcemen firm o arrive a he measure DD for each half-day inerval of he even period, days ED=-17 o ED=-1, and DD b for he benchmark period, days ED=-20 o ED=-18. These DD and DD b should be free of all passage of ime effecs. For each announcemen i and half-day inerval (over days ED=-17 o ED=-1), he difference beween he even period and benchmark period measures of deviaions from pu-call pariy (Q i, ) are calculaed as: Equaion 4 Q i, = DD i, = DD i,b If here is no maerial change in he pu-call pariy relaionship during he preannouncemen period, Q i, will be insignificanly differen from zero. If on he oher hand, here is a maerial change in securiy prices such ha he pu-call pariy relaionship changes in he preannouncemen period, Q i, will be significanly differen from zero. Q i should be negaive (posiive) for posiive (negaive) earnings announcemens if he opions marke leads he sock marke. If he sock marke leads he opions marke Q i, should be posiive (negaive) for posiive (negaive) announcemens. Any differences from zero in he Q i, may persis for several inervals, depending on he benefis and coss of informed rading in he lagging marke. Though i is difficul o hypohesize he duraion of a significan difference, saisically significan differences from zero indicae a high probabiliy of rading aciviy in one marke ha leads ha in he oher marke prior o earnings announcemens. EMPIRICAL RESULTS In Table 2, he resuls for earnings announcemens greaer han expeced (he op 25 percen of surprises) are presened for he pre-itsa period. The firs half of a rading day is denoed wih he suffix.1 and he las half is denoed wih he suffix.2. The maximum number of observaions per half-day inerval is 90 and he minimum is 66 wih an average of 73.69. For each inerval he average Q i, across firms, denoed Q,, and he proporion of Q i, greaer han zero, are examined. The resuls in Table 2 are supporive of a leading sock marke. Thiry of he 34 inervals have Q s ha are greaer han zero and a proporion of posiive Q i s of a leas 50 percen. A a 5 percen significance level, 11 of he 34 inervals (ED=-13.2, -12.1, -11.1 o -9.1, -8.1, -6.2, -5.1, and -4.1) have posiive Q s ha are saisically differen from zero. Three of he 34 inervals (ED=-13.2, -11.1, and -8.1) have a proporion of posiive Q i s ha is significanly greaer han 50

The Lead-Lag Relaionship Beween The Opion And Sock Markes 47 percen by a sign es. Thus, he opions marke lags he sock marke prior o he release of posiive earnings surprises in he pre-itsa period. However, in he case of earnings announcemens less han expeced (boom 25 percen) in he same ime period, Table 3 presens evidence of an opions marke lead. Thiry-wo of he 34 inervals have posiive Q s and 33 of he 34 inervals have a proporion of posiive Q i s greaer han 50 percen. Nine of he 34 inervals (ED=-17.2, -16.1, -12.1, - 11.1, -10.1, -10.2, -9.1, -6.1, and -4.2) have Q s ha are significanly differen from zero. Seven of he 34 inervals have a proporion of posiive Q i s ha are significanly greaer han 50 percen. For negaive earnings surprises in he pre-itsa period, he evidence suppors a leading opions marke. For he pos-itsa period, resuls in Tables 4 and 5 are presened for good and bad news announcemens, respecively. Neiher Tables 4 or 5 sugges any lead role for eiher he opions marke or sock marke. In Table 4, half of he 34 inervals have Q s greaer han zero and none are significanly differen from zero. The proporion of posiive Q i s is no saisically differen from 50 percen for any inerval. Similar resuls prevail in Table 5 as well where 12 of he 34 inervals are posiive and none of he inervals has a Q significanly differen from zero. None of he 34 inervals have a proporion of posiive Q i s ha is significanly differen from 50 percen. Two subses of our sample are also examined o deermine if cerain observaions are causing he paerns deeced. The firs includes only he op and boom en percen of earnings surprises, as measured by marke-adjused reurns. These surprises may provide he greaes incenive o rade on privae informaion. The second examines he mos acively raded halves, in erms of opion volume, of he iniial 25 percen favorable and unfavorable surprises. These opions may provide he bes opporuniies for informed raders o conceal heir rades. For boh subses, however, resuls are similar o he full sample. Overall, he paerns provide ineresing resuls. Given he special advanages of opions wih shor posiions and he relaively lax scruiny of insider opion rading prior o he passage of ITSA, he mos likely occurrence of an opions marke lead is for negaive news earnings announcemens in he pre-itsa period. Empirically, his is he only sample where an opions marke lead is found. Somewha surprisingly, here is a sock marke lead for good news in he pre- ITSA period. These resuls sugges ha shor sale consrains are an imporan facor influencing informed rading. I is also hypohesized ha afer he passage of ITSA insiders may be more relucan o use heir privae informaion, leading o a dampening of any lead-lag relaionships. The pos-itsa resuls for boh good and bad news are consisen wih his hypohesis. The resuls are also consisen wih Chan, Chung, and Johnson [6], who find no lead-lag relaionships in he pos-itsa period. CONCLUSION This sudy examines lead-lag relaionships beween he sock and opion markes prior o subsanial earnings surprises, when informed raders would have subsanial incenives o rade. The inheren advanages of rading in he opions marke sugges a possible leading role, especially for negaive surprises. Any leading role for he opions marke should be miigaed afer he passage of ITSA. This paper employs bid and ask quoes of calls and pus obained from he Berkeley opions daa base, pu-call pariy relaionships, and a conrol sample mehodology o invesigae lead and lag paerns beween he sock and opion markes over a 17-day period prior o earnings surprises. Resuls indicae ha in he pre-itsa period, he opions marke leads he sock marke for negaive surprises bu for posiive surprises he sock marke leads. Afer he passage of ITSA here is no leading role for eiher marke. These resuls sugges ha insiuional facors, such as shor sale consrains, and regulaory inensiy may affec relaive price paerns beween he sock and opion markes. ENDNOTES 1. Arshadi and Eyssell [4] find ha ITSA curbed insider rading before ender offer announcemens and Eyssell and Reburn [10] find ha ITSA reduced insider rading before he issuance of common sock. 2. The daily marke-adjused reurn is calculaed for each firm by subracing he equally-weighed CRSP index reurn of New York and American Sock Exchange securiies from he firm s sock reurn on a daily basis. Firms wih declaraions of dividend changes from day ED=-20 hrough ED=0 are deleed since he pu-call pariy measure employed assumes ha dividend amouns are known wih cerainy. Dividend informaion is obained from CRSP. Treasury securiy yields serve as a proxy for risk free ineres raes and are obained from he Wall Sree Journal. Due o he influences of he crash, announcemens in Ocober and November, 1987, are also eliminaed.

48 Journal of Financial and Sraegic Decisions 3. They are also saisically differen from zero a he 1 percen significance level. 4. The benefi of pu-call pariy is ha i allows he calculaion of an implied sock price boundary wihou assuming he validiy of an opion pricing model or consan reurn variances. Furhermore, hough previous sudies of he lead-lag relaionship had used only call prices o arrive a an implied sock price, pu-call pariy incorporaes informaion from pu prices as well. 5. These saisics should also be serially uncorrelaed if here is an underlying ime series process common o boh conrol and earnings announcemen opions. 6. The raio of exercise price o sock price is examined for he earnings announcemen firm and conrol firm for he firs opion quoaions in he inerval ED=-12 o ED=-8. REFERENCES [1] Affleck-Graves, J., R. Jennings, and R. Mendenhall, Evidence of Informed Trading Prior o Earnings Announcemens, Working Paper, New York Universiy, 1994. [2] Amin, K. and C.M.C. Lee, Opion Trading and Earnings News Disseminaion, Working Paper, Universiy of Michigan, 1994. [3] Anhony, J.H., The Inerrelaion of Sock and Opions Marke Trading-Volume Daa, Journal of Finance 43, Sepember 1988, pp. 949-964. [4] Arshadi, N. and T.H. Eyssell, Regulaory Deerrence and Regisered Insider Trading: The Case of Tender Offers, Financial Managemen 20, Summer 1991, pp. 30-39. [5] Bhaacharya, M., Price Changes of Relaed Securiies: The Case of Call Opions and Socks, Journal of Financial and Quaniaive Analysis 22, March 1987, pp. 1-16. [6] Chan, K., Y.P. Chung, and H. Johnson, Why Opions Prices Lag Sock Prices: A Trading-Based Explanaion, Journal of Finance 48, December 1993, pp. 1957-1967. [7] Cox, J.C. and M. Rubinsein, Opions Markes, Prenice Hall, Englewood Cliffs, N.J., 1985. [8] Damodaran, A. and J. Lim, Pu Lising, Shor Sales Resricions and Reurn Processes, Working Paper, New York Universiy, 1992. [9] Ellio, J., D. Morse, and G. Richardson, The Associaion Beween Insider Trading and Informaion Announcemens, Rand Journal of Economics 15, 1984, pp. 521-536. [10] Eyssell, T.H. and J.P. Reburn, The Effec of The Insider Sancions Ac of 1984: The Case of Seasoned Equiy Offerings, Journal of Financial Research 16, Spring 1993, pp. 161-170. [11] Figlewski, S. and G.P. Webb, Opions, Shor Sales, and Marke Compleeness, Journal of Finance 48, June 1993, pp. 761-777. [12] Finucane, T.J., Pu-Call Pariy and Expeced Reurns, Journal of Financial and Quaniaive Analysis 26, December 1991, pp. 445-457. [13] Jarrow, R.A. and A. Rudd, Opion Pricing, Richard D. Irwin, Homewood, IL., 1983. [14] Kyle, A.S. and J.L. Villa, Noise Trading and Takeovers, Rand Journal of Economics 22, 1991, pp. 54-71. [15] Manaser, S. and R. Rendleman, Jr., Opion Prices as Predicors of Equilibrium Sock Prices, Journal of Finance 37, Sepember 1982, pp. 1043-1057. [16] Meulbroek, L.K., An Empirical Analysis of Illegal Insider Trading, Journal of Finance 47, December 1992, pp. 1661-1699. [17] Paell, J.M. and M.A. Wolfson, The Ex Ane and Ex Pos Price Effecs of Quarerly Earnings Announcemens Refleced in Opion and Sock Prices, Journal of Accouning Research 19, Fall 1981, pp. 434-458. [18] Sehyun, H.N., The Effeciveness of The Insider-Trading Sancions, Journal of Law and Economics 35, 1992, pp. 149-182. [19] Sephan, A. and R.E. Whaley, Inraday Price Change and Trading Volume Relaions in The Sock and Sock Opion Markes, Journal of Finance 45, March 1990, pp. 191-220.

The Lead-Lag Relaionship Beween The Opion And Sock Markes 49 TABLE 2 Measures of Change in Pu-Call Pariy for Earnings Announcemens Greaer han Expeced in he Pre-ITSA Sub-period ED is he half-day even period relaive o he disclosure of he earnings announcemen where.1 refers o rading before 12 p.m. and.2 refers o rading afer 12 p.m. Q measures average deviaions from pu-call pariy. Q less han zero indicaes an opions marke lead and Q greaer han zero indicaes a sock marke lead. The -saisic is he es saisic for evaluaing wheher Q = 0. Percen > 0 is he proporion of Q i greaer han 0. A proporion of posiive Q i less han.5 indicaes an opions marke lead and a proporion of posiive Q i greaer han.5 indicaes a sock marke lead. ED Q -saisic p-value Percen > 0 Sign p-value -17.1 0.024 0.97 0.337 0.535 0.635-17.2 0.026 1.33 0.186 0.545 0.494-16.1-0.006-0.26 0.799 0.478 0.810-16.2 0.007 0.33 0.741 0.507 1.000-15.1 0.027 1.18 0.241 0.500 1.000-15.2-0.011-0.49 0.623 0.507 1.000-14.1 0.017 0.72 0.476 0.541 0.561-14.2 0.014 0.56 0.579 0.590 0.141-13.1 0.039 1.41 0.164 0.566 0.302-13.2 0.064* 2.72 0.008 0.651* 0.008-12.1 0.061* 2.06 0.043 0.587 0.165-12.2 0.032 1.49 0.139 0.526 0.734-11.1 0.077* 2.55 0.013 0.632* 0.029-11.2 0.079* 2.58 0.012 0.613 0.057-10.1 0.076* 2.82 0.006 0.600 0.093-10.2 0.068* 2.25 0.028 0.589 0.160-9.1 0.078* 2.28 0.026 0.595 0.130-9.2 0.046 1.57 0.121 0.571 0.254-8.1 0.094* 2.81 0.006 0.625* 0.044-8.2 0.023 0.77 0.442 0.526 0.731-7.1 0.032 1.11 0.271 0.539 0.567-7.2 0.062 1.99 0.051 0.582 0.222-6.1 0.057 1.79 0.078 0.569 0.289-6.2 0.065* 2.16 0.034 0.597 0.125-5.1 0.064* 2.36 0.021 0.533 0.644-5.2 0.057 1.74 0.087 0.493 1.000-4.1 0.086* 2.38 0.020 0.592 0.154-4.2 0.049 1.36 0.179 0.527 0.728-3.1-0.024-0.85 0.396 0.427 0.248-3.2 0.011 0.36 0.719 0.478 0.810-2.1 0.034 1.04 0.302 0.529 0.720-2.2-0.010-0.35 0.725 0.522 0.810-1.1 0.022 0.73 0.468 0.552 0.464-1.2 0.022 0.66 0.509 0.500 1.000 * Q significanly differen from zero by wo-ailed -es a a 5 percen significance level or proporion of posiive Q i s significanly differen from 50 percen by a wo-ailed sign es a a 5 percen significance level.

50 Journal of Financial and Sraegic Decisions TABLE 3 Measures of Change in Pu-Call Pariy for Earnings Announcemens Less han Expeced in he Pre-ITSA Sub-period ED is he half-day even period relaive o he disclosure of he earnings announcemen where.1 refers o rading before 12 p.m. and.2 refers o rading afer 12 p.m. Q measures average deviaions from pu-call pariy. Q greaer han zero indicaes an opions marke lead and Q less han zero indicaes a sock marke lead. The -saisic is he es saisic for evaluaing wheher Q = 0. Percen > 0 is he percenage of Q i greaer han 0. A proporion of posiive Q i greaer han.5 indicaes an opions marke lead and a proporion of posiive Q i less han.5 indicaes a sock marke lead. ED Q -saisic p-value Percen > 0 Sign p-value -17.1 0.034 1.64 0.107 0.597 0.142-17.2 0.037* 2.01 0.049 0.615 0.082-16.1 0.052* 2.33 0.023 0.614 0.072-16.2-0.000-0.00 0.998 0.485 0.902-15.1 0.048 1.76 0.083 0.603 0.114-15.2 0.040 1.40 0.166 0.547 0.532-14.1 0.043 1.62 0.110 0.563 0.342-14.2 0.042 1.57 0.121 0.625 0.060-13.1 0.032 1.21 0.231 0.597 0.142-13.2 0.023 0.79 0.434 0.545 0.539-12.1 0.065* 2.17 0.034 0.603 0.114-12.2 0.053 1.87 0.065 0.575 0.242-11.1 0.060* 2.01 0.048 0.629* 0.041-11.2 0.050 1.60 0.116 0.627* 0.050-10.1 0.092* 3.10 0.003 0.642* 0.027-10.2 0.065* 2.13 0.037 0.657* 0.014-9.1 0.081* 2.90 0.005 0.657* 0.012-9.2 0.048 1.63 0.108 0.603 0.114-8.1 0.040 1.44 0.155 0.627* 0.050-8.2 0.041 1.54 0.128 0.529 0.720-7.1 0.049 1.44 0.155 0.551 0.470-7.2 0.052 1.54 0.129 0.629* 0.041-6.1 0.059* 2.07 0.043 0.576 0.268-6.2 0.045 1.58 0.120 0.580 0.228-5.1 0.054 1.66 0.101 0.543 0.550-5.2 0.045 1.38 0.172 0.538 0.620-4.1 0.041 1.46 0.150 0.562 0.382-4.2 0.091* 2.48 0.016 0.591 0.175-3.1 0.050 1.48 0.143 0.576 0.268-3.2 0.022 0.59 0.557 0.525 0.795-2.1 0.025 0.78 0.436 0.557 0.443-2.2 0.034 1.13 0.265 0.550 0.519-1.1 0.037 1.04 0.305 0.607 0.141-1.2-0.011-0.36 0.718 0.518 0.894 *Q significanly differen from zero by wo-ailed -es a a 5 percen significance level or proporion of posiive Q i s significanly differen from 50 percen by a wo-ailed sign es a a 5 percen significance level.

The Lead-Lag Relaionship Beween The Opion And Sock Markes 51 TABLE 4 Measures of Change in Pu-Call Pariy for Earnings Announcemens Greaer han Expeced in he Pre-ITSA Sub-period ED is he half-day even period relaive o he disclosure of he earnings announcemen where.1 refers o rading before 12 p.m. and.2 refers o rading afer 12 p.m. Q measures average deviaions from pu-call pariy. Q less han zero indicaes an opions marke lead and Q greaer han zero indicaes a sock marke lead. The -saisic is he es saisic for evaluaing wheher Q = 0. Percen > 0 is he proporion of Q i greaer han 0. A proporion of posiive Q i less han.5 indicaes an opions marke lead and a proporion of posiive Q i greaer han.5 indicaes a sock marke lead. ED Q -saisic p-value Percen > 0 Sign p-value -17.1-0.017-0.81 0.418 0.435 0.178-17.2 0.021 0.94 0.348 0.510 0.920-16.1-0.004-0.21 0.835 0.424 0.089-16.2 0.005 0.21 0.832 0.486 0.847-15.1-0.024-1.17 0.245 0.458 0.407-15.2 0.006 0.22 0.824 0.423 0.155-14.1-0.009-0.41 0.680 0.459 0.415-14.2-0.040-1.64 0.105 0.438 0.261-13.1-0.012-0.51 0.614 0.504 1.000-13.2-0.036-1.40 0.164 0.420 0.133-12.1-0.013-0.55 0.581 0.450 0.294-12.2-0.013-0.49 0.623 0.476 0.696-11.1 0.044 1.83 0.069 0.538 0.430-11.2 0.006 0.27 0.789 0.517 0.783-10.1 0.007 0.29 0.776 0.488 0.860-10.2 0.002 0.09 0.926 0.491 0.924-9.1 0.042 1.72 0.088 0.565 0.162-9.2 0.030 0.93 0.353 0.490 0.921-8.1 0.036 1.29 0.198 0.586 0.063-8.2 0.047 1.63 0.106 0.546 0.387-7.1 0.004 0.16 0.877 0.469 0.539-7.2-0.005-0.18 0.857 0.485 0.844-6.1-0.028-1.14 0.258 0.439 0.191-6.2-0.002-0.07 0.948 0.519 0.769-5.1 0.040 1.73 0.087 0.566 0.145-5.2 0.031 1.20 0.234 0.577 0.141-4.1-0.010-0.41 0.685 0.257 0.597-4.2 0.013 0.47 0.637 0.514 0.845-3.1 0.023 0.84 0.402 0.512 0.857-3.2 0.014 0.49 0.623 0.510 0.920-2.1-0.006-0.21 0.837 0.520 0.721-2.2-0.036-1.25 0.215 0.505 1.000-1.1-0.013-0.39 0.696 0.508 0.927-1.2-0.043-1.41 0.161 0.477 0.699 *Q significanly differen from zero by wo-ailed -es a a 5 percen significance level or proporion of posiive Q i s significanly differen from 50 percen by a wo-ailed sign es a a 5 percen significance level.

52 Journal of Financial and Sraegic Decisions TABLE 5 Measures of Change in Pu-Call Pariy for Earnings Announcemens Less han Expeced in he Pos-ITSA Sub-period ED is he half-day even period relaive o he disclosure of he earnings announcemen where.1 refers o rading before 12 p.m. and.2 refers o rading afer 12 p.m. Q measures average deviaions from pu-call pariy. Q greaer han zero indicaes an opions marke lead and Q less han zero indicaes a sock marke lead. The -saisic is he es saisic for evaluaing wheher Q = 0. Percen > 0 is he percenage of Q i greaer han 0. A proporion of posiive Q i greaer han.5 indicaes an opions marke lead and a proporion of posiive Q i less han.5 indicaes a sock marke lead. ED Q -saisic p-value Percen > 0 Sign p-value -17.1-0.017-0.77 0.442 0.490 0.922-17.2-0.039-1.69 0.094 0.439 0.218-16.1-0.022-0.93-0.355 0.468 0.566-16.2-0.015-0.59 0.554 0.447 0.353-15.1-0.025-1.02 0.312 0.466 0.555-15.2-0.017-0.58 0.561 0.506 1.000-14.1-0.047-1.96 0.053 0.447 0.324-14.2-0.010-0.40 0.693 0.530 0.661-13.1 0.020 0.70 0.483 0.509 0.923-13.2 0.022 0.75 0.457 0.522 0.752-12.1 0.019 0.79 0.430 0.495 1.000-12.2-0.018-0.58 0.565 0.488 0.914-11.1-0.009-0.35 0.727 0.470 0.617-11.2-0.001-0.03 0.977 0.473 0.679-10.1 0.000 0.01 0.996 0.476 0.696-10.2-0.052-1.57 0.121 0.435 0.251-9.1 0.010 0.46 0.647 0.504 1.000-9.2 0.008 0.29 0.773 0.495 1.000-8.1 0.036 1.36 0.178 0.530 0.579-8.2 0.047 1.44 0.155 0.596 0.089-7.1 0.038 1.15 0.253 0.556 0.290-7.2 0.013 0.41 0.686 0.562 0.289-6.1-0.007-0.26 0.799 0.519 0.769-6.2-0.006-0.19 0.849 0.505 1.000-5.1 0.022 0.73 0.470 0.495 1.000-5.2-0.036-0.96 0.341 0.467 0.598-4.1 0.004 0.16 0.875 0.485 0.842-4.2-0.013-0.45 0.654 0.511 0.917-3.1-0.011-0.39 0.700 0.455 0.426-3.2-0.026-0.81 0.419 0.433 0.246-2.1 0.002 0.06 0.950 0.495 1.000-2.2-0.022-0.81 0.420 0.517 0.830-1.1-0.035-1.20 0.234 0.455 0.391-1.2-0.001-0.03 0.977 0.470 0.617 *Q significanly differen from zero by wo-ailed -es a a 5 percen significance level or proporion of posiive Q i s significanly differen from 50 percen by a wo-ailed sign es a a 5 percen significance level.