Informational Content of Option Volume Prior to Takeovers

Abstract

This paper examines the information embedded in both the stock and option markets prior to takeover announcements. During normal periods, buyer-seller initiated stock volume imbalances are significant predictors of next-day stock returns and option volume imbalances are uninformative. However, prior to takeover announcements, call volume imbalances are strongly positively related to next-day stock returns. Cross-sectional analysis shows that those takeover targets with the largest pre-announcement call-imbalance increases experience the highest announcement-day returns. The largest increase in buyer-initiated trading activity is in short-term out-of-the-money calls that subsequently experience the largest returns. Collectively, these findings are consistent with the hypothesis that, in the presence of pending extreme informational events, the options market plays an important role in price discovery.