Is Reversal of Large Stock-Price Declines Caused by Overreaction or Information Asymmetry : Evidence from Stock and Option Markets

We reexamine the role of option markets in the reversal process of stock prices following stock price declines of 10 percent or more. We randomly select a matched-pair of optionable and non-optionable firms when their price declines of 10 percent or more on the same date. We examine the 1,443 and 1,018 matched-pairs of NYSE/AMEX and NASDAQ firms over the period from 1996 to 2004. We find that the positive rebounds for non-optionable firms are caused by an abnormal increase in bid-ask spread on and before the large price decline date. On the other hand, the bid-ask spreads for optionable firms decrease on and before the large price decline date. We also find an abnormal increase in open interest and volume in the option market on and before the large price decline date. Overall, our results suggest that the stock price reversal is not a result of overreaction, nor can it be simply explained by bid-ask bounce