Options Trading Activity and Firm Valuation

Richard Roll, Eduardo Schwartz, and Avanidhar Subrahmanyam

The Issue

• Ross (1976) -- options can improve market efficiency by expanding contingencies covered by traded securities

• Agents should be able to trade more effectively on their information, thus improving informational efficiency

The Issue, contd.

• Cao and Wei (2007) find that informational asymmetries are greater for options relative to stocks.

• Easley, O’Hara and Srinivas (1998), Chakravarty, Gulen, and Mayhew (2004) find that option orders contain information about future stock prices

The Issue, contd.

• If prices reveal more information, then resources are allocated more efficiently, which translates to higher firm valuations.

• Also, greater informational efficiency reduces investment risk because market prices reflect information more precisely.

• These arguments imply that firms with higher options trading volume should be more informationally efficient and thus valued more highly.

A point of clarification

• The mere listing of an option does not necessarily imply a valuation benefit.

• If the options market has insufficient volume, the valuation benefit from listing would be minor because informed traders see no advantage to trading in options (Admati and Pfleiderer, 1988).

• Any valuation benefit of options listing should depend on the amount of trading activity.

• To the best of our knowledge, the relation between options trading activity and firm valuation has not been examined previously.

The Analysis

• We analyze the effect of options trading volume on firm value after controlling for other variables that may also affect firm value such as firm size, share turnover, return on assets, capital expenditures, leverage and dividend payments.

• Following other studies we use a measure of Tobin’s q as the valuation metric.

Findings

• We find strong evidence that firms with more options trading have higher value.

• Firms with more options trading activity in a given period tend to have improved financial performance in the next period.– This accords with the premise that options

trading, by enhancing information flows, may lead to better corporate resource allocation.

Findings, contd.

• The results indicate that the effect of options trading on firm valuation is greater in stocks with low analyst following. – This indicates that the impact of options on

information production more in stocks where investment analysis produces comparatively less public information.

Data

• Options trading data from option metrics – 1996 to 2005

• Tobin’s q is computed as the sum of the market capitalization of the firm’s common equity, the liquidation value of its preferred stock, and the book value of its debt divided by the book value of the firm’s assets.

Control variables

• A proxy for the firm’s leverage, long-term debt to total assets, is intended to measure the likelihood of distress.

• Profitability, ROA, intended to capture the notion that more profitable firms may have more favorable investment opportunities. On the other hand, high ROA may mean that the firm is in a mature phase, and has limited growth opportunities.

• The relation between ROA and q is an empirical issue.

Controls, contd.

• A direct measure of investment opportunities is capital expenditures divided by sales—high values should mean greater q.

• A dummy variable for whether the firm pays a dividend proxies for capital constraints (firms that pay dividends may have more free cash flow, which may potentially be used to overinvest in marginal projects).

Number of firms with nonmissing data

Correlation matrices

Correlation matrices, contd.

• The correlation between q and options volume is strongly positive

• q is negatively related to leverage as well as the dividend dummy

Figure 1: Average Tobin’s q vs. options volume

Regression results – sample of firms with positive options

volume

Regression results – panel estimation

Summary of results

• Tobin’s q is positively and significantly related to options trading

• q is also negatively related to leverage and the dividend dummy, consistent with the proposed hypotheses.

• Stock trading activity also bears a positive relation with q

Endogeneity

• One could argue, albeit implausibly, that high q firms may attract more attention and this may translate to greater options volume.

• We need an instrument for options volume that is inherently unrelated to q. Finding such an instrument is a difficult endeavor and inevitably involves an element of subjectivity.

An instrument

• We propose that options volume may be related to the average absolute moneyness, the relative difference between the stock’s market price and the option’s strike price.

Rationale for instrument

• Since the vega of an option is highest at-the-money, agents speculating on volatility would prefer at-the-money options for their greater sensitivity.

• On the other hand, for someone without volatility information, at-the-money options have the greatest exposure to volatility risk and hence may be eschewed for this reason.

• Moreover, it could also be the case that informed traders may be attracted to out of the money options because they provide the maximum leverage, but uninformed traders may migrate to in the money options to avoid risky positions.

Rationale for instrument, contd.

• The preceding arguments provide a link between absolute moneyness and options volume, but do not specify an unambiguous direction, which remains an empirical issue.

• There is no reason, however, that moneyness should be inherently related to q, since exchanges periodically list new options with strike prices close to the recent market price of the underlying stock, so there should be no mechanical link between moneyness and stock prices.

Computing the instrument’s value

• We calculate the annual average of the daily absolute deviation of the exercise price of each option from the closing price of the underlying stock.

• For option k on stock j for day t, the absolute deviation is |ln(pricej,t/strikek)|. This is averaged

over all k and t within a year for each stock j.

IV estimation

Results with log(options volume)

Year-by-year coefficients on options volume (dependent variable – Tobin’s q)

Options and future firm performance

• If options trading activity leads to better corporate resource allocation, then there may be a relation between future firm profitability and options trading

• We regress ROA on lagged values of options volume and control variables

Firm performance and options trading

Firm performance and options

• There is a positive relation between future ROA and current options activity

• This supports the information channel: that more options trading is associated with greater informational efficiency, which, in turn, leads to improved resource allocation.

Other robustness checks

• Results are robust to scaling options volume by shares outstanding,

• Return volatility and analyst following are not significant in the regression for Tobin’s q

A role for analyst following

• The effect of options in information production may be greater in stocks with low analyst following, where little public information is produced.– In these cases private information may play a

stronger part in information production

Testing the impact of analyst following

• We divide the sample each year into three groups by analyst following, and label them 0,1,2.

• We interact options volume with this indicator variable and include the interaction variable in the regression

Regression results with interaction variable for analyst following

Interpretation of results with inclusion of analyst following

• The impact of options volume on Tobin’s q is stronger in firms with less analyst following.

• Suggests private information production is more important in stocks where investment analysts produce less public information

Conclusion

• The amount of options trading is associated with higher firm valuations.

• This result is consistent with the dual notions that more options trading is associated with greater informational efficiency of prices and superior resource allocation.

• The results survive when subjected to a variety of robustness checks, including different specifications of volume.

Conclusion, contd.

• There is a positive link between future firm performance and current options volume, suggesting that options trading enhances information production and, in turn, resource allocation.

• The role of options volume on valuation is stronger in firms with less analyst following where it is likely that less public information is produced– In these stocks, private information production

through trading may be more important for resource allocation

Issues of Interest

• The key point of our paper is that the degree to which an option is traded, not its mere listing, is associated with higher valuations.

• It would be interesting to consider whether this notion extends to other scenarios.

• For example, some countries have futures contracts on individual stocks, and the effect of such contracts on valuation could be ascertained.

• Analyzing the impact of index options and futures on market valuation would also be of interest.