Returns to Option Strategies Following Class Action Lawsuits

Abstract

Turmoil and uncertainty confront firms when they are named as defendants in class action lawsuits. In this article, we consider whether option markets interpret the implications of these dramatic corporate events for mid- to long-term performance. In particular, we consider relatively simple, long, volatility-based combined option positions. We find consistent, positive, and frequently significant returns to option straddle and strangle positions held from 6 months to 1.5 years after a firm is targeted in a class action. This may be indicative of underappreciation, in the option markets, for the dichotomous nature of firm stock price performance as the class action proceeds toward a resolution.

TOPICS: Legal/regulatory/public policy, performance measurement, volatility measures, derivatives, options

Key Findings

• • Long volatility-based straddle and strangle option positions are a potentially profitable strategy if stock markets fail to appreciate the dichotomous nature of price movements after class action lawsuits begin.

• • Straddles and strangles are consistently profitable for holding periods between 6 months and 1.5 years if created after the initial filing of a class action lawsuit.

• • The median time from the initial filing of a class action lawsuit until resolution is 717 days.