Growing Option Trading Volumes<\/span><\/h2>\nEquity options are contracts that give one party the right (but not the obligation) to buy or sell a certain number of shares at a pre-agreed price (exercise price) before a certain date (maturity date). Equity options are frequently traded – with hundreds of millions of contracts being traded every month – and have substantially grown in popularity in the last few years, with the number of contracts traded almost doubling over the last three years.<\/span><\/p>\nEquity options are an example of a \u201cderivative\u201d contract, as their value is derived from that of the stocks they refer to. Consequently, any piece of news or withheld information that has an impact on a stock’s price will also affect the price of its associated options, potentially harming option holders. The options market has been growing steadily in size over the last few years. In 2021, the volume of options publicly traded on US stocks exceeded 40 million contracts.<\/span><\/span><\/span><\/em><\/p>\nSource:\u00a0 Quartz.com, CBOE<\/span><\/em><\/h6>\nOption Damages in US Security Fraud Allegations<\/span><\/h2>\nFideres reviewed a sample of publicly available settlement plans from the last 20 years and found that option holders are rarely mentioned in class definitions. When reviewing these cases, we discovered two key distinct methodologies that were employed when trying to assess the losses option holders faced in relation to securities fraud.<\/span><\/p>\nMethodology 1 – Raw Difference Between Pre and Post Disclosure Option Prices<\/span><\/h3>\nUnder this methodology, inflation can be calculated based on the raw price drop of the option in question in relation to misinformation disclosures. The recognized loss for options from a given disclosure date can then be simply computed as the difference between the option\u2019s price before the disclosure and the price after it.\u00a0Experts used this methodology when assessing damages to call option holders in the 2009 Bank of America case surrounding the bank\u2019s merger with Merrill Lynch.<\/span><\/p>\nMethodology 2 – Repricing of Options Using Counterfactual Stock Prices<\/span><\/h3>\nThis methodology requires the use of a specified option pricing model to compute two option prices – an \u201cactual\u201d price computed using observed stock prices, and a counterfactual price, computed with the same model, but using the counterfactual stock price. Damages can then be calculated as the difference between these two option prices.<\/span><\/p>\nUnlike the methodology involving raw option price drops this procedure allows experts to isolate the impact caused by a change in underlying stock price separately from changes caused by trading noise, time value decay, or other disclosures. We were able to see this procedure in practice when reviewing the 2005 AIG accounting scandal. This approach, however, assumes the stock price to be the only relevant variable in option pricing. As shown in the next section, this can be a grave mistake, potentially misclassifying damages for option holders.<\/span><\/p>\nImplied Volatility – An Important Factor to Consider<\/span><\/h3>\nIn both approaches to damages assessment, experts have attempted to account for price changes when developing their methodology; however, they disregarded a major determinant of option prices: implied volatility (IV).\u00a0 Implied volatility is a measure of the uncertainty of a stock\u2019s future price, measuring the likelihood of the range of the possible future prices. IV has a positive impact on options prices, as a wider range of potential future prices increases the potential upside of the contract, without affecting its potential downside, as option holders will only exercise options that are favorable to them.<\/span><\/p>\nThe Impact of Implied Volatility<\/span><\/h2>\nIgnoring implied volatility can have grave consequences when determining the magnitude and directionality of damages for option holders, which may lead to challenges during class certification. To illustrate this point, we briefly analyze the movement of option prices following an announcement by Twitter from April 2022 and the impact this announcement had on option holders.<\/span><\/p>\nTaking Twitter Private<\/span><\/h3>\nOn April 25, 2022, the board of Twitter approved of an acquisition offer by Elon Musk to take the company private. In the aftermath of the announcement, Twitter\u2019s share price rallied due to resulting investor excitement. All else equal, this price spike should have caused the value of call options (options to buy) to increase – as the same option now allows the holder to buy something more expensive. However, as shown in the chart below, call options prices decreased instead.\u00a0<\/span><\/span><\/span><\/em><\/p>\n