Informed trading prior to financial misconduct: Evidence from option markets

This paper shows an abnormal level of option trading activities in the ten days before the revelation of financial misconduct in a sample of the SEC and/or DOJ enforcement actions. These abnormal option trading volumes are negatively associated with the subsequent stock returns to the announcements, and are positively linked to firm penalty, the number of violations, prison sentences, fraud charge, top executives number, potential firm deception toward auditors, impeded investigation, and violation period. Finally, abnormal option trading is related to the time to discovery and the likelihood of discovery. These results suggest that option traders detect firms engaged in financial misconducts.