Analyst Recommendations and Option Market Reactions

This paper examines the effect of analyst stock recommendations on equity option market activity in US over the 1996 to 2002 period. I find that the implied volatilities of recommended stocks gradually increase up to the recommendation revision date and stay at the increased level after the revision, especially following downgrades. This pattern, however, seems to reflect changes in the past realized volatilities more than ex post future realized volatilities, indicating that option market may be overreacting to recommendation revisions. A delta hedged trading strategy that shorts call options on recommendation revision date yields significant positive profits before transaction costs, supporting the overreaction hypothesis. Analysis of cumulative returns and abnormal trading volume prior to the revision further suggests that there is more information trading in option market than in stock market.