Option Listing on the Equity of Newly Public Firms

Abstract

We show that equity prices of newly public firms decrease immediately after options have been listed, and that this effect persisted for one year. Relative to a similarly matched IPO firm without options listed, stock returns of a newly public firm fall by 75 bps per week after options start trading. Analyzing the determinants of this equity underperformance, we find a permanent threefold increase in short-interest ratio and aggressive insider selling in IPO equity following option listing. There is an overwhelming demand for put options on newly public firms for up to five months after options have been listed. A simple strategy that buys newly listed put options on IPO stock and held to maturity yields up to 6.3% monthly excess returns after transaction costs. Overall, we find that option listing relaxes short-sales constraints on IPO equity, thereby correcting short-run overvaluation.

Keywords: IPOs; Option listing; Long-run stock returns; short-sale constraint

JEL Classification: G14; G12; G24