What information do informed traders use?

Abstract

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