The Decline of Informed Trading in the Equity and Options Markets

Abstract

Reliable excess returns from active portfolio management derive from informed trading. We investigate the information content of informed trading in the equity market and the options market. We find that informed equity trading and options trading are positively correlated in the time-series, but virtually uncorrelated cross-sectionally. Portfolio-level and stock-level analyses provide robust evidence that the cross-sectional return predictive power of informed trading in each market is distinct. Time-series analyses indicate that aggregate informed options trading is useful for predicting market returns, but that the amount of informed trading has declined significantly in more recent years. The time-series patterns of both our informed trading measures coincide closely with the decline in equity hedge fund excess returns.

Keywords: informed trading, hedge funds, implied volatility, stock return predictability

JEL Classification: G10, G12, G14