Informed Trading in the Stock Market and Option Price Discovery

When activist shareholders file Schedule 13D filings, the average excess return on target stocks is 6% and stock price volatility drops by about 10%. Prior to filing days, volatility (price) information is reflected in option (stock) prices. Using a comprehensive sample of trades by Schedule 13D filers which reveals on what days and in what markets they trade prior to filing Schedule 13D, we show that on days when activists accumulate shares, option implied volatility decreases, volatility skew increases, and option bid-ask spreads widen. The adverse selection risk in options is driven by the volatility component of private information and is higher when stock and option markets are highly integrated. The evidence is consistent with informed trading in the stock market contributing to the flow of volatility information into option prices.