What information do informed traders use?
44 Pages Posted: 21 Jul 2022 Last revised: 14 Aug 2023
Date Written: June 30, 2022
Informed trading plays a crucial role in financial markets. However, the question remains: how do informed traders gain their edge? We study option traders – an important class of informed traders – and find that their trades used to strongly predict future stock returns. However, the put-call ratio and other measures that aggregate the information content of options trades suddenly and permanently ceased to predict stock returns after October 2009. This timing coincides with the arrest of Raj Rajaratnam and the launch of an unprecedented campaign against insider trading. We hypothesize that insider trading in the options market drove the return predictability, which stopped after Rajaratnam’s arrest. Our empirical tests support this hypothesis and rule out alternative explanations, indicating that insider trading was more common than previously thought.
Keywords: Informed trading, equity options, return predictability, insider trading
JEL Classification: G10, G14
Suggested Citation: Suggested Citation