Informed Trading in the Stock Market and Option-Price Discovery

Using a comprehensive sample of trades from Schedule 13D filings by activist investors, we show that both directional and volatility information is reflected in stock and option prices. Option prices reflect the adverse selection risk associated with the volatility component of private information rather than the directional component. We then study the role of informed trading in price discovery and find that activists choose to trade stocks and to not trade derivatives in about 98% of cases. When they use derivatives, they typically seek to increase their overall economic exposure to the stock. We find that on days when activists accumulate shares, option implied volatility decreases and volatility skew increases. We conclude that informed trading in the stock market contributes to the flow of volatility information into option prices.