Options Analysts' Recommendations and Market Efficiency

Options Analysts' Recommendations and Market Efficiency DON M. CHANCE RAMAN KUMAR This study examines call option recommendations of analysts quoted weekly in Barron's. Results show that stock prices rose prior to the publication date and fell thereafter. Calls purchased by the public on the publication date or by clients at the time the recommendations were identified earned insignificant returns if held to expiration. Calls purchased by clients at the time of the recommendations and sold on the publication date earned a significant mean return often percent, which is not annualized and generated over at most five days. However, these returns appeared to be consumed by the risk inherent in call option buying.

I. INTRODUCTION

The performance of stock market analysts' forecasts has been studied extensively in the literature. Previous studies, however, have focused on analysts who recommend stocks. In this paper, the recommendations of analysts who specialize in options are examined. These analysts supply information privately to clients and subsequently offer that information essentially free to the public in Barron's weekly options column, ''The Striking Price." Options analysts are a particularly interesting group to study. Since options are more complex instruments than primary securities, many options analysts begin their careers in stocks (or bonds) and work their way up to the options departments of their firms. Thus, a good securities analyst could know little about options. 1 With the exception of analysts who specialize in options on futures, which is not the concern here, it is virtually impossible to conceive of an options analyst knowing little about stocks. Therefore, it would be expected that options analysts might be more talented and experienced than other financial analysts. Whether they are or not, however, does not imply that their recommendations are necessarily superior or inferior to those of stock analysts. A study of their performance is worthwhile and can contribute to an understanding of the efficient markets hypothesis. In particular, analysts who supposedly have special skills and/or private information and who supply that information to clients are appropriate subjects for investigation of the efficient market hypothesis. Analyzing and recommending option strategies is more difficult than analyzing and recommending stocks. An analyst could recommend an option on the basis of fundamental and/or technical factors that present a given outlook for the underlying security. The option then serves Don Chance • Professor, Department of Finance, Insurance & Business Law, The R. B. Pamplin College of Business, Virginia Polytechnic Institute and State University, Blacksburg, VA 24061; Raman Kumar • Associate Professor of Finance, Virginia Polytechnic Institute and State University, Blacksburg. International Review of Financial Analysis, Vol.1, No.2, 1992, pp. 131-148. ISSN: 1057-5219 Copyright e 1992 by JAI Press, Inc., All rights of reproduction in any form reserved.

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simply as a leveraging device, designed to exploit, at somewhat greater risk, the expected performance of the stock. Alternatively and sometimes in conjunction, the option itself is deemed to be misvalued with res~ct to the stock price and is recommended on that basis. Thus, it may be difficult to determine the reasoning behind a particular recommendation, at least not without boldly assuming that the exact valuation model used by the analyst is known. Fortunately for the present study, the analyst group provided their reasons, which seldom (if at all) mentioned misvaluation of the option. Data are presented on the reasons for their recommendations later, but at this point, it is emphasized that the overwhelming majority of the recommendations were based on the expected outlook for the underlying stock. Not only does this simplify the task, but it also suggests that an examination of the performance of the stock is a good indicator of the quality and impact of the recommendations.

II. PREVIOUS STUDIES OF ANALYSTS' RECOMMENDATIONS Previous studies of analysts' forecasts have focused on stock recommendations and the process by which recommendations are disseminated to the market. One such study is the Lloyd-Davies and Canes (1978) analysis of the recommendations appearing in 1970-71 in The Wall Street Journal's (WSJ) daily column, "Heard on the Street." The analysts were known to have provided the recommendations to their clients prior to publication in WSJ. The results show that buy recommendations exhibited abnormal positive returns prior to the publication date and an abnormal return of almost 1% on the publication date. Sell recommendations produced an abnormal return on the publication date of -2.4%. In addition, the sell recommendations show abnormal negative returns following the publication date but not prior to that time. Groth, Lewellen, Schlarbaum and Lease ( 1979) examine the performance of stocks recommended by a large brokerage firm over the period 1964-70. Using monthly data and over 6,000 recommendations, they find a significant abnormal return of about 1.8% in the month of the recommendation, but no abnormal performance prior to or after the recommendation date. Groth et. al. (1978) examine the differential performance of various securities analysts. They observe considerable variation in talent, with the top half of the analysts showing significantly better performance than the bottom half. Using essentially the same data set, Stanley, Lewellen and Schlarbaum (1981) conclude that the firm's customers in fact appeared to act on the analysts' recommendations. Bjerring, Lakonishok and Vermaelen (1983) examine the recommendations of Canadian analysts over the period 1977-81 using weekly data. They find a significant abnormal return of 1.5% during the week of the recommendation, which is still significant even after adjusting for commissions. Similar conclusions are drawn in several well-known studies of the Value Line phenomenon (Copeland and Mayers 1982, Black 1973). In none of these studies do the researchers find evidence that abnormal returns on the announcement date were followed by abnormal returns of the opposite sign thereafter. Had this result been found, it would be evidence that the announcement conveyed no information, but merely triggered a buying or selling spree that was subsequently corrected. Thus, they conclude that analysts do convey valuable information to investors. In spite of the plethora of studies on the performance of stock analysts' recommendations, options analysts have not been examined at all. One possible reason for this is that options analysts' recommendations are not as widely publicized. Of course, there are fewer options

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analysts to begin with and many analysts and even a few brokerage firms refuse to trade in options, as well as other derivative instruments. Trading options requires greater knowledge and, perhaps most importantly, options suffer from the stigma of being highly levered, speculative instruments. Thus, in spite of the vast body of sophisticated literature on options, the performance of specific recommendations has not been examined.2

Ill. DATA AND METHODOLOGY As noted earlier, the recommendations examined in this study were taken from Barron's weekly column, ''The Striking Price." This column, published on Monday of each week, reports on option market activity during the previous week. It identifies the options that had large price changes, provides general news about options markets, and quotes specific analysts' opinions about their recommended options. About 40% of the recommendations mention the current price of the option, which is, of course, by the time of publication a non-current price. The analysts usually recommend options on common stocks but sometimes endorse options on stock indices, bonds, futures or foreign currencies. Because of an insufficient number of options in these categories, this study focuses exclusively on options on common stocks.

Description of the Sample Normally, a particular analyst is quoted every two to three weeks. The recommendations include call purchases, put purchases, covered calls, call spreads, put spreads and various other strategies. Information was collected on option recommendations over the period January 27, 1986 through March 23, 1987. A total of 316 recommendations were made by 18 analysts. As discussed in more detail later, the objective was not only to examine the performance of the option but also to observe the behavior of the stock around the recommendation date. Since daily stock price data were required, the University of Chicago Center for Research in Security Prices (CRSP) daily returns file was used. Since at the time the study was completed the file included the period through the end of 1986, recommendations in which the option expired after 1986 were eliminated. The remaining recommendations consisted of long calls, covered calls, long puts, and spreads. However, there were not enough covered calls and spreads to justify examination. Also, there were only 29 put recommendations, eight of which were on indices not available in the CRSP file, and those were eliminated as well. Thus, the final sample consisted of 161long call recommendations where all the calls were on exchange-traded stocks with data available on the CRSP file. These recommendations were on options on 119 different stocks. ffiM and International Paper had the most recommendations (four each). There were 12 analysts who made one or more recommendations. To protect the analysts' privacy, each is referred to by a number, and Table 1 presents the number of recommendations for each analyst. Table 2 presents summary information on the degree of moneyness and the expirations of the recommended calls. More than 60% of the recommendations were essentially at-the-money. Fewer than 2% were deep out-of-the-money and less than 6% were deep in-the-money. While about 50% of the expirations were between one and three months, the overall range seems quite large. The average was 68 days, the median was 60, the maximum was 214 and the minimum was 18.

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Table 1 The Number of Usable Call Option Purchase Recommendations Made by Each of Fourteen Analysts Quoted In Ban-on's Over the Period January 27,1986 through March 23, 1987. Analyst

Number of Usable Recommendations 3 2 4

2 3 4 5 6 7 8 9 10 II 12

6 6 54 21 3 48 12 161

Table 2 Frequency D~tribution of Moneyness and Time to Expiration of the 161 Recommended Calls. Moneyness ~ Defined as M _ Stock Price - Exercise Price Exercise Price

Degree of Moneyness

Number of Cells

M:s: -10% -10%
3 20 101 28 9

Total

161

Days to Expiration 0-29 30-59 60-89 90-119 < 120 Total

23 48 46 27 17 161

Pet 1.86 12.42 62.73 17.39 5.59

14.29 29.81 28.57 16.77 10.56

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Evaluating the Performance of the Options Evaluating the performance of option transactions is difficult. Techniques such as those developed by Galai and Geske (1984) and Galai (1983) require the construction of a risk-free hedge based upon a presumed valuation model. Thus, these procedures become a joint test of the valuation model and the analysts' ability. Another approach, which Evnine and Rudd ( 1984) suggest, applies an equilibrium-asset pricing theory such as the APT to evaluate the option's risk-reward tradeoff. Such an approach, while feasible in theory, still requires the assumption of a relative valuation model for options as well as an equilibrium model for all risky assets. Thus this approach is a three-way joint test of an option pricing model, an asset pricing model and the analysts' ability. Fortunately for this study, at least one of the problems (the use of a valuation model) appears to be of less concern. The comments of the analysts were examined to determine if their recommendations were based on the perception of the option mispriced relative to the stock or on simply the outlook for the stock. Table 3 presents a classification of each recommendation by its basis. The largest number of recommendations was based on technical analysis. The second largest number cited the high leverage of the call. This group, which was in fact a single analyst (#8 in Table 1) always stated that the option was expected to appreciate by a given percent if the stock price appreciated by a given, but lower, percent. This seems to imply that the analyst was bullish on the stock. Of course, leverage is a characteristic of nearly all options and could be a factor in the recommendations of the other analysts. The only real concern, however, was that an analyst was not recommending the option because it was undervalued relative to the stock. Since each of those recommendations mentioned how the option would perform if the stock price increased, the conclusion of no perceived misvaluation of the option with respect to the stock seems justified. Another large group of recommendations was clearly based on general bullishness of the stock. Finally, three recommendations that could have been based on misvaluation were

Table3 Oassification of the Reasons Cited by Each Analyst for Recommendation of Each CaD Option. (The classification "High leverage'' was based on the analyst mentioning that the options would be expected to appreciate by a certain percent if the stock price appreciated by a certain (lower) percent.) Basis Chart patterns, technical factors High leverage Takeover Bullishness on stock Undervalued call Total

Number

63 54 I 40 3 161

Percent

39.13 33.54 0.62 24.84 1.86

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observed. However, even that classification is unclear. To be specific, the analyst mentioned that time premiums on index options were high and that the risk-reward ratio was better on the three equity options recommended. Allowing for the possibility that these three recommendations were based on misvaluation of the calls with respect to the stock, the sample still overwhelmingly consisted of calls recommended on the basis of the expected performance of the stock. Thus, the analysts appeared to accept the efficiency of the options market relative to the stock market but questioned the efficiency of the stock market relative to the information

set Thus, information about the analysts' ability can be gleaned by examining the performance of the stock during the period surrounding the date of the recommendation. The recommendations appeared in Barron's on Mondays. The stock's performance was examined for a period of 40 trading days prior to and 40 trading days after the Monday of the recommendation. The abnormal performance of stock i was estimated by calculating the abnormal return from the familiar market model, (1)

=

where t -40, ... , 0, ... , + 40. The a; and~; were estimated in a regression of the security's return on the CRSP value-weighted market index over the 250-trading-day period, L290 to t-4 1, prior to the examination period. For each time point, t =-290, ... , -41, the residuals were averaged across all firms to produce an overall series of residuals, er--29(), ... ,et--4t· The standard deviation of this series was then calculated to derive an overall standard deviation of the abnormal returns. This was then divided into each of the average abnormal returns, t =-40, ... , +40 to produce at-statistic. These results should provide evidence of the performance of the stock prior to and after the announcement date of the recommendation. However, they are not sufficient to determine the analysts' ability. For one, the performance of the recommended calls would reflect the leverage characteristics of the options. In addition, the options would capture both systematic and unsystematic components of return while the event analysis would reflect only the unsystematic stock returns. Accordingly, the actual performance of the options was examined. It was assumed that public investors bought the option at the closing price on the Monday on which Barron's was published.3 Further, cases in which the investor bought the option at the close on the Friday and on the Thursday before the Monday on which the recommendation was made in Barron's were also examined. This established a price before the time the recommendation was made in Barron's and provided some information about the value of having the recommendation shortly before the public gets it. It should be noted that the analysts' comments provided little information about whether the recommendations should be held to expiration. The analysts would be expected to provide private information to their clients about when to close their positions, but in no cases were specific public recommendations made to close positions established from previous recommendations. Thus, a public investor would be required to use his or her own judgment about closing a position early. Since it would be imprudent to arbitrarily make such a judgment, the positions were simply held to expiration. The value of the option on its expiration date and the rate of return on the option were then calculated. As noted earlier, adjusting option returns for risk is a particularly difficult exercise. The state of the art in option performance evaluation requires the use of a valuation model. The generally

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accepted valuation models produce risk measures that are strictly correct only over instantaneous holding periods. Since these options would be held to expiration, it would be unwise to carelessly apply such models to adjust for the risk. While the Thursday and Friday closing prices provided information about the returns to transactions initiated before the recommendations were made public, there was also an additional piece of similar information for a subset of the recommendation. In some of the recommendations, the analyst quoted the option price at the time the recommendation was made to Barron's. This was several days prior to the publication date. There were 64 such cases, almost all of them made by two analysts. Thus, it was assumed that those transactions were recommended to clients at the quoted prices prior to the publication date. Then when Barron's was published, those prices might be no longer available. Those transactions were then examined to determine if the analysts' clients could have made significant returns by buying at the analysts' quoted prices at the time the recommendation was made to them and then selling the options when the information was made public by its appearance in Barron's. If the difference between the quoted price, which was the price at which the analyst was recommending the option, and the price actually available when the recommendation was made public were significant, then the analyst could be credited with having provided value for the clientele. A strategy of buying the option when the analyst recommends it to the client and selling it when the recommendation becomes public might be highly profitable. Even if the analysts did not specifically give the recommendations to clients, the issue is still the same. The analyst privately quoted a price at which an option purchase was recommended. Several days later, the recommendation was made public. What happened to the options during that time is indicative of the analysts' ability. Since in these cases the holding periods would be far shorter than when the public purchases the call on the publication date and holds it to expiration, some type of risk adjustment could possibly be applied.

IV. THE RESULTS Stock Price Performance Around Call Option Recommendation Date The Complete Sample. Table 4 presents the abnormal returns and t-statistics for the combined recommendations of all of the analysts. Although the period t = -40 ... ,+40 was examined, to conserve space only the 20-day window around the publication date is presented. Note that of the 21 abnormal returns, 17 are positive. In fact, for the 40-day period prior to the publication date, only 11 abnormal returns are negative. The probability of such a result is less than 1% in the normal approximation to the binomial. However, 24 of 40 abnormal returns following the publication date are negative. The abnormal returns are significant at t -9, -8, -4, and -3 and almost at t =-5. At t =-3, the return was highly significant with a t-statistic of over 5.4 The cumulative abnormal returns (CARs) are illustrated in Figure I. They exhibit the tendency to rise steadily beginning about 30 days prior to the publication date and sharply about 10 days prior to the event. They then begin falling within four days after the publication date. At 40 days after the event, they have not yet returned to zero. Although the CARs continue to rise for three days after the publication date, the averages are not significant, so anyone

=

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Table4 Abnonnal Return Perfonnance of Common Stocks on Which Call Options were Recommended. Day

-10 -9 -8 -7 -{j

-5 -4 -3 -2 -I 0 I 2 3 4

5 6 7 8 9 10

Abnormal Return

t-statistic

0.000016 0.003047 0.004062 0.000025 0.000733 0.002283 0.004176 0.006097 0.000390 0.000635 0.000118 0.000370 0.000349 0.001322 -0.002078 0.000224 -0.002017 -0.000502 0.000350 -{).000104 0.000041

0.01 2.58* 3.44* 0.02 0.62 1.93 3.54* 5.16* 0.33 0.54 0.10 0.31 0.30 1.12 -1.76 0.19 -1.71 -{).43 0.30 -{).09 0.03

•Denotes significance at .05 level. This table includes recommendations made by all analysts. Day 0 is the Monday publication date.

purchasing on the event day would not earn abnormal returns. In fact, if the stock were purchased on the event day and held for a relatively long period of time, the investor would lose money. Only if the stock were purchased prior to the publication of the recommendation would abnormal returns be possible. The CAR from day -4 to zero was .011416, which has a t-statistic of 4.33. The CAR from day -3 to zero was .00724, which has at of 3.07. Round-trip transaction costs and the bid-ask spread, however, would have consumed these amounts. Thus, while the recommendations appear to have predictive power, abnormal returns after transaction costs are not necessarily earned. Depending on when the analysts identified the call prior to day zero, they may well have been identifying stocks that were undervalued. They could have been detecting the trend in the rising residuals that began about 35 days prior to the publication date. This suggests that there may be a problem with the benchmark period. To investigate this possibility, the market model alphas over this period, day -290 to -41, were examined to determine if the mean alpha is significantly

Options Analysts' Recommendations, Market Efficiency

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0.06 0.04 0.02

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u

0 -0.02 -0.04 -0.06 -0.08

-40

-30

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20

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40

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different from zero. Using the t-test, the Wilcoxon signed-ranks test and the sign test, the mean alpha is not significantly different from zero. As a further check on the validity of the benchmark period, a future benchmark period, day +41 to +290, was employed and the abnormal returns for days -40 to +40 were re-estimated. This produces virtually the same graph as Figure 1 and the tests on the average residuals were significant on the same days as they had previously been significant using the -290 to -41 benchmark. Thus, there is no evidence that a selection bias resulting from the analysts' choice of stocks with recent outstanding performance contaminated the results. Another possible explanation for these results is that the analysts were simply recommending stocks that had important and positive information releases during that week. To examine this possibility, The WSJ Index was reviewed for the week during which the recommendation was made. For 54 out of the 161 recommendations, there was a story mentioned in The WSJ Index in the week preceding the recommendation date. However, this is not an unusual number given the set of rather large firms involved. More importantly, there was no pattern of positive news releases. At some time prior to the offering of the information to Barron's, the analyst provides it to the frrm's clients. Thus, the timing of the availability of the information is critical. Barron's indicated that they telephone the analyst during the Monday-to-Friday period prior to the weekend in which the publication is produced. The column then appears on the newsstands on Monday. Barron's receives recommendations during the Monday-Thursday period and sometimes confirms with the analyst on Friday that the recommendations are still supported. Thus,

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TableS Abnormal Return Performance of Common Stocks on which CaD Options were Recommended by Analyst. Analyst# Day -10 -9 -8 -7 -6

-5 -4 -3 -2 -1 0 2 3 4

5 6 7 8 9 10

No. of recommendations

8 ...{).000328 0.004938* 0.003287 ...{).000154 0.000328 0.002083 0.002427 0.001128 -0.000516 ...{).002894 0.001890 ...{).000677 0.000106 ...{).000205 ...{).002416 0.001704 0.003527 0.000510 0.002245 ...{).001490 0.001236 54

9 O.!XH094 0.004875 ...{).005773 0.000647 0.003262 ...{).000406 ...{).002153 0.000913 0.001248 0.003657 0.006815* 0.003048 ...{).000923 0.005459 0.003147 ...{).000521 ...{).002708 ...{).002525 ...{).001038 -0.001999 0.003704 21

11 0.001447 0.001863 0.010864* 0.001564 0.002757 0.004732* 0.009558* 0.013138* 0.002473 0.003454 -0.000806 0.001076 0.001258 0.002262 ...{).003882 ...{).001862 ...{).004785* ...{).002660 0.000071 0.000796 0.001852 48

12 ...{).001241 ...{).004017 0.001793 ...{).002493 ...{).001671 -0.001962 ...{).002552 0.015043* ...{).006759 -0.004128 -0.012253* -0.003639 ...{).004591 0.003791 -0.003077 0.001839 ...{).004419 ...{).004005 -0.006603 0.003060 ...{).000726 12

Other -0.002204 0.003089 0.002106 -0.001780 -0.003094 0.002309 0.006091 0.003478 0.001035 0.002519 -0.001554 0.000927 0.002486 -0.001721 -0.001809 0.000860 -0.006757* 0.004629 0.001262 0.001182 -0.008389* 26

*Denores significance at .05 level. Day 0 is the Monday publication date.

it is reasonable to presume that the recommendations were made prior to Friday. Since the analysts would have offered them to their clients first, the clients would almost certainly have had the recommendations a few days earlier. Thus, it is possible that the clients could have captured the abnormal returns of .4% and .6% on days t -4 and t =-3, respectively. They should then sell at the time the information reaches the general public through the pages of Barron's because there is no abnormal performance remaining. That analysts can provide value to clients is entirely consistent with an efficient market. As Grossman and Stiglitz (1980) show, some informational inefficiencies will exist as long as there is a non-zero cost of exploiting them. Cornell and Roll ( 1981 ), using a biological conflict model, find that security analysis will be a justified activity for some individuals, wherein its marginal cost will equal its marginal return. The analysts examined here do, as a whole, appear to provide value for their clients, depending again on the timing. Whether that marginal value exceeds the marginal cost of their services cannot easily be determined. However, it is clear that the value

=

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of their recommendations to the public at large is roughly equivalent to the cost of acquiring that information. In other words, you get what you pay for.

Analyst Subsamples. To examine the analysts' performance on an individual basis, analysts #8, 9, 11, 12, and a combined category of the remaining analysts, called "Others,'' were examined. (As Table 1 indicates, none of the "Other" analysts had more than six recommendations.) Table 5 presents the abnormal returns. The t-statistics are omitted to conserve space, but the significant returns are indicated. The CARs for the full 80-day window around the event are shown in Figures 2(a)-2(e). It seems apparent that analyst #11 was superior to the others. All of the abnormal returns on this analyst's recommendations were positive prior to the publication date and four were highly significant. Three of the significant abnormal returns occurred during the week in which the recommendations were offered with the largest abnormal return being Wednesday's 1.3%. For the full40-day period prior to the publication date, the average abnormal returns on this analyst's recommendations were positive in 27 of 40 cases, an occurrence which has a probability of2%. For the post-event period, 24 of 40 were positive, a statistically insignificant number. It thus appears that the value identified by Analyst #11 was not reversed after the recommendations were made. This suggests that the stocks on which calls were recommended were not simply ones that had temporarily risen in value. However, caution is advised in evaluating this analyst's pre-event performance because the timing of the identification of the option relative to the public announcement is critical. Of the remaining analysts, #9, with an abnormal return of .68% on the publication date, and #12, with 1.5% on day t = -3, appear to have contributed some value but not as much as #11. Since the analysts were recommending options on these stocks, the leverage factor would significantly boost their clients' returns above these figures. (The option returns will be examined in the next section.) Analyst #8 also shows some evidence of outstanding performance, with the CARs rising prior to the publication date and falling very little thereafter. Analyst #12, however, appears to be identifying stocks that rose prior to the publication date but fell sharply thereafter. The "Other" analysts category showed no ability to identify stocks with superior performance. In fact, the residuals show a marked tendency to decline after the publication date. It is tempting to conclude that Analyst #12 and the Other category might even be viewed as contrarian indicators. There seems to be a relationship between the number of recommendations made and the quality of the recommendations, a point also noted in Groth et. al. (1978). It was observed that analysts #8 and #11 apparently produced the best performance and the most recommendations. The worst performance seems to be that of the "Other" group, which consists of the combined recommendations of analysts who made fewer than seven recommendations. This relationship between the quality and the quantity of recommendations suggests that the analysts who were identifying value were aware of the quality of their work and were confident enough to offer more recommendations than were the others. The Performance of the Options

Table 6 presents the statistics on the performance of the options for both the overall sample and groups of analysts. Panel A focuses on the transactions initiated at the closing prices on the

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DAY

2. Cumulative abnormal returns of common stocks on which call options were recommended broken down by analyst

FIGURE

Options Analysts' Recommendations, Market Efficiency

143

Monday on which Barron's was published. In the overall sample the average return was 14.6% with a standard deviation of 193.4%. The median return was a 100% loss and a third of the transactions were profitable. The t-statistic of0.961 is not significant; however, call returns are well known to be characterized by skewness, which biases the t-test. Johnson's ( 1978) adjusted t-statistic, presented in the next column, is used to minimize the effect of skewness on the t-test. 5 Even after the adjustment, however, none of the individual analysts had significant positive returns on the recommendations when held from the publication date to expiration. Panel B presents the performance based on buying at the Fri"ay closing price and Panel C presents the performance based on buying at the Thursday closing price. 6 With the exception

Table6 Statistics on Rates of Return of Recommended Call Options. N A.

161 48 21 54 12 26

0.146 0.254 0.351 0.202 -0.623 0.021

1.934 1.636 2.296 1.999 0.863 2.349

-1.000 -0.391 -1.000 -1.000 -1.000 -1.000

0.961 1.076 0.700 0.744 -2.502 0.047

1.047 1.226 0.845 0.820 -1.386 0.151

32.3 43.8 38.1 29.6 16.7 23.8

155 46 20 53 12 24

0.232 0.369 0.441 0.360 -0.619 -0.061

2.037 1.772 2.150 2.362 0.873 2.064

-1.000 -0.178 -0.704 -1.000 -1.000 -1.000

1.420 1.414 0.917 1.110 -2.455 -0.145

1.560 1.670 1.067 1.241 -1.379 -0.033

34.8 45.7 45.0 30.2 16.7 25.0

154 46 20 53 12 25

0.193 0.307 0.390 0.299 -0.533 -0.107

2.189 1.646 2.191 2.188 0.965 2.188

-1.000 -0.309 -0.656 -1.000 -1.000 -1.000

1.217 1.264 0.797 0.996 -1.747 -0.245

1.332 1.450 0.951 1.101 -1.212 -0.109

34.4 45.7 45.0 30.2 20.0 20.0

64 48 13

0.306 0.280 --0.056

1.941 1.653 1.593

-0.527 -0.208 -1.000

1.260 1.173 -0.127

1.463 1.352 --0.055

40.6 41.7 30.8

Thursday Closing Prices

Overall Analyst #II Analyst #9 Analyst #8 Analyst #12 Other Analysts D.

Adjusted* t % Profitable

Median

Friday Closing Prices

Overall Analyst #II Analyst #9 Analyst #8 Analyst #12 Other Analysts

c.

a

Monday Closing Prices

Overall Analyst #II Analyst #9 Analyst #8 Analyst #12 Other Analysts B.

x

Analysts' Quoted Prices

Overall Analyst #II Analyst #9

*Johnson's (1978) adjusted t-statistic, which accounts for skewness. See footnote 5. Positions were assumed to be held to expiration. In Panel A, trades are initiated at the closing price of the option on the publication date. In Panels B and C trades were initiated at the closing price of the option on the Friday and Thursday, before the publication date, respectively. In Panel D, trades were initiated at the price quoted by the analyst. The totals for analysts II and 9 are less than the overall total because the remaining three recommendations were insufficient to analyze separately.

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Table7 Statistics on Percentage Changes In CaD Option Prices between Recommendation and Publication Dates.

Overall Analyst #II Analyst #9

X

a

.102 .079 .193

0.345 0.366 0.289

Median 0.050 0.289 0.158

Adjusted t 2.358 1.503 2.407

62.5 58.3 76.9

%Positive 2.751 1.733 2.459

•Johnson's (1978) adjusted !-statistic, which accounts for skewness. See footnote 16. This represents the performance of the options between the time the options were quoted to Barron's at a given price and the time the recommendations were made public.

of the poor performance of analyst #12, the results were not significant but the means were slightly higher than the means produced when the options were bought on Monday. The prices may have risen slightly from Thursday or Friday to Monday, but not by much. Panel D of Table 6 presents the results for strategies recommended at the analysts' quoted prices. It is reasonable to expect that such prices might be more favorable. The adjusted t-statistic for the overall group was significant at only about the 14% level and the adjusted t for Analyst #11 was significant at only about the 18% level. However, it is interesting to note that the performance was improved when using these earlier prices to initiate the transaction than when buying on Thursday, Friday or Monday. The average return was about twice as high as Monday's average for the overall sample and slightly higher for analyst #11, who accounted for three-fourths of the transactions initiated at the analysts' price. To conclude that the analysts' quoted prices give more favorable results in general may be unwise. This is because the sample was concentrated on one or two analysts, and thus removes the effects of other, perhaps poorer-performing analysts. However, this result suggests that a closer look should be taken at what happened to the options from the time of the recommendation to the time of publication. Table 7 provides an indication of how the options performed between the time the analysts quoted their recommendations and the time the recommendations appeared in print. That is, for those transactions in which an analyst quoted an option price, the percentage change in the price from the analysts' quote to the closing price on the Monday of publication was computed. The average call increased by I 0%, which was statistically significant at better than the 1.0% level. Analyst #11 's recommendations increased by an average of 7 .9%, which was significant at the 8.3% level, and Analyst #9's recommendations increased by an average of 19.3% which was significant at the 1.4% level. These rates are not annualized and were earned over a period of less than one week. There are many possible explanations for these results. If the analysts had inside information, they might generate abnormal returns, which would violate strong-form efficiency but certainly be consistent with the literature on insider trading. No information is available on whether the analysts consistently had inside information but it is seriously doubted that this was the case. Another possible explanation is that the publication of the recommendation itself drove the call prices up. Nevertheless, even if that were true, the client recommendations were still valuable. It could be argued that the performance of these strategies reflected simply riding the crest of a strong bull market. If that were the case, however, the returns to the strategies held to expiration should be significant and greater by a factor reflecting the average number of days

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to expiration, but this did not occur. Analyst #11 generated an average return of 7.9% over the few days between the recommendation date and the publication date. The average for positions opened by this analyst at the recommendation date and held to expiration was 28%, and the average for positions opened at the publication date and held to expiration was 25%. The average expiration for analyst #11 's options was 95 days. Analyst #9 generated an average of 19.3% between recommendation date and expiration date and 35% between publication date and expiration date. 7 The average option expiration for this analyst was 75 days. Thus, if these large returns between recommendation date and publication date were simply the effects of the bull market, the returns to longer transactions would have been much larger than those observed here. Another possible explanation is that the analysts quoted unrealistic prices. They could have systematically quoted low prices or prices at which they recommended purchase of the options, whether such prices were available or not Yet, these possibilities seem unlikely when one considers the highly significant abnormal performance of the stock in the week of the recommendation. The large price increases on the options between the recommendation date and the publication date are entirely consistent with the abnormal performance of the stock over that same time period. On the other hand, the prices quoted by the analysts might not actually be available to the investor. Prices can change substantially between the time the analyst identifies the option and the time the client can execute a trade. Finally, there is the all-important matter of the risk of the option. In order to determine if abnormal returns have been earned, an estimate of the option's expected return is required. It can easily be shown that over any holding period,

E(rc) - r + (E(rs) -

r)Ec

(2)

where E(rc) is the expected return on the call, E(rs) is the expected return on the stock, r is the risk-free rate and Ec is the elasticity of the option price with respect to the stock price. For the special case where expected stock returns are well proxied by the Capital Asset Pricing Model,

(3)

where E(rc) is the expected return on the market portfolio and f3c is the beta of the call, which is given as

(4) where f3s is the beta of the stock. In order to obtain the elasticity, some type of valuation model, such as Black and Scholes (1973) is required. However, the Black-Scholes model provides an instantaneous estimate of the elasticity. There are no known procedures for obtaining an accurate estimate of the option's elasticity over a finite holding period. Thus, the limitations of such a risk adjustment must be recognized Since the evidence suggests that there may be abnormal returns over a one-to-fiveday holding period, it seemed worthwhile to proceed with this risk adjustment but to be cautious in the interpretation of its results. Another problem encountered in the risk adjustment is not knowing on which day (-4 to -1)

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the analyst made the recommendation. The conservative approach is to assume day -4, as this gives the longest holding period, and thus should have produced the highest expected return. The market return over day -4 to day 0 was computed, and the 90-day t-bill rate quoted on the publication date was used as a proxy for the risk-free rate. The Black-Scholes model was then used to solve for the implied volatility of the option, which simultaneously produced an elasticity measure. 8 Both equations were employed for computing the expected return on the call, the first using the stock's expected return, estimated as the actual return on the stock, and the second based on an estimate of the option's beta, taken from the product of an estimate of the stock's beta obtained over the estimation period, and the option's elasticity estimate. The differences were negligible, so only the case using the option beta is reported. The average expected return over the five-trading-day period is .072, leaving an average abnormal return of .029, which is not significant using either the t-test or the sign test. The results for Analyst #9, however, show an average abnormal return of .148, which was significant at the .03 level using the t-test and the .07 level using the sign test. One must be careful in drawing conclusions from these results because, as discussed earlier, adjusting for the risk of options is an extremely difficult process. It is apparent that the risk is not trivial. For the analyst group in general, the risk appears to consume all of the significance of the return. What is left is not significant and would be further eroded by transaction costs. For analyst #9, the 13 recommendations may well have earned abnormal returns: if almost 15% a week is an accurate estimate, transaction costs would have been covered. Nevertheless, to label this analyst's results as truly abnormal is perhaps unwise, since there remains the question of whether the client could have actually obtained these favorable prices.

V. CONCLUSIONS This study examines the performance of call option recommendations made by analysts quoted weekly in Barron's column, 'The Striking Price." It is divided into two parts: the behavior of the underlying stocks around the recommendation date, and the performance of the options. The behavior of the abnormal returns on the stock suggests that the analysts may have indeed identified undervalued stocks. The cumulative residuals rose sharply prior to the announcement but fell afterward. This suggests that the public could not have earned abnormal returns by trading on the announced recommendation. However, there were several highly significant abnormal returns observed within a few days prior to the announcement. Since the analysts reported their recommendations to Barron's within a few days of the publication date, their clients might have had the information in time to capture the abnormal returns. Returns on the call options based on holding them to expiration show no evidence of significant positive returns. However, approximately 40% of the recommendations supplied a current price of the option, which permitted a determination of the returns their clients could have earned had they acted on the analysts' recommendations and closed their positions when the recommendations were made public. A statistically significant average return of about 10% was found. This figure, not annualized, was earned over a period of at most five trading days. Even if the analysts did not specifically make the recommendations to their clients, the performance of the options between the recommendation and publication dates was still quite impressive. While the difficulties of making an accurate risk adjustment for options should be appreciated,

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these estimations reveal that the risk would have consumed a significant portion of the return, the remainder of which was then statistically insignificant and would have been further consumed by transaction costs. Still, one analyst, from whom only 13 recommendations were available, does exhibit possibly an average abnormal return. However, there remains the question of whether the clients could have actually obtained the prices quoted by the analysts. The overall results show that the analysts did indeed identify underpriced stocks. The performance of those stocks and their call options was impressive during the period between the identification of the stocks and the date of publication of the recommendations. That it was difficult to convert these recommendations into abnormal returns is indicative of the high risk and cost of trading.

ACKNOWLEDGMENTS The authors would like to thank Jack Broughton, Tom Dorsey, Margaret Pacey and the referees, and an associate editor for helpful comments and Doug Eckel, En Yang Guo, Peter Ammermann and Jon Schmidt for assistance in data collection. The views expressed here are those of the authors.

Notes l. For example, there are analysts who concentrate on small stocks on which there probably are no options available. Many firms and analysts refuse to deal in options because in their opinion, options are considered excessively speculative. 2. This is not meant to imply that options have not been empirically tested. The simulation studies of Merton, Scholes, and Gladstein (1978, 1982) and a number of others in various journals have contributed to an understanding of the performance of options. However, none of those studies tested specific recommendations of analysts. 3. Since there were no simultaneous stock purchases, the non-simultaneity problem, common in the options literature, is not a factor here. 4. Given that Barron's is published on Monday, which is day zero, the question may be raised as to whether the "Monday effect" could contaminate the results. The answer is that it could not since this effect is observed in total returns and not abnormal returns, which are examined here. To be certain, however, the abnormal returns over the 48 Mondays during the benchmark period, day -290 to -40, were examined. The average Monday residual return was significant (and positive) on one Monday. Using a future benchmark estimation period of day +41 to day +290 for verification, three significant abnormal returns, one negative and two positive, were obtained. The number significant is clearly within the bounds expected for a Type I error at an alpha level of .05. Thus, there is no "Monday effect" contaminating the results. 5. The adjusted tis given as (X -~-t) + ~2N +

(-Ta4) (X -~-t)2

vs 1N 2

where X is the sample mean, N is the sample size, ll is the hypothesized population mean, llJ is the third moment, a2 is the population variance and S 2 is the sample variance. ll = 0 and the sample estimates of 1!3 and a are used. The statistic's use in testing option returns is examined in Boyle and Emanuel (1980).

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6. Due to an occasional non-trading Friday or Thursday these purchases were backed up to the prior trading day. 7. That Analyst ##9 generated much lower returns if options were held to expiration when purchased on the recommendation date (rather than on the publication date) appears inconsistent with the finding that this analyst generated a highly significant 19.3% average between recommendation date and publication date. However, the result is explained by the fact that several recommendations in which the analyst did not quote a price performed extremely well. (The options could only be purchased on the publication date.) 8. Note that solving for the implied volatility assumes that the option is correctly priced with respect to the stock price. This is entirely consistent with the earlier evidence (Table 3) that the options were recommended on the basis of factors other than undervaluation of the option relative to the stock.

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23-27. Galai, D. 1983. 'The Components of the Return from Hedging Options Against Stocks." Journal of Business 56 :45-54. Galai, D. and R. Geske. 1984. ''Option Performance Measurement." Journal of Portfolio Management

10:42-46. Grossman, S. J. and J. E. Stiglitz. 1980. ''On the Impossibility of Informationally Efficient Markets." American Economic Review 10: 393-408. Groth, J. C., W. G. Lewellen, G. G. Schlarbaum, and R. C. Lease. 1979. "Analysis of Brokerage House Recommendations." Financial Analysts Journal35: 32-40. - - - . 1978. "Security Analysts: Some Are More Equal." Journal of Portfolio Management" 4: 43-48. Johnson, N.J. 1978. "Modified T-tests and Confidence Intervals for Asymmetrical Populations." Journal of the American Statistical Association 73: 536-544. Lloyd-Davies, P. and M. Canes. 1978. "Stock Prices and the Publication of Second-hand Information." Journal of Business 51:43-56. Merton, R. C., M. S. Scholes, and M. L. Gladstein. 1978. "The Returns and Risks of Alternative Call-Option Portfolio Investment Strategies." Journal of Business 51: 183-242. - - - . 1982. ''The Returns and Risks of Alternative Put-Option Portfolio Investment Strategies." Journal of Business 55: 1-55. Stanley, K. L., W. G. Lewellen, and G. G. Schlarbaum. 1981. "Further Evidence on the Value of Professional Investment Research." Journal of Financial Research 4: 1-9.