Straddle Option Profitability In Corporate Lawsuits

Abstract

The current study investigates whether abnormal returns may be gained by purchasing a straddle position prior to a verdict or settlement announcement in a lawsuit.  The basis for the hypothesis stems from behavioral finance—more specifically, the Overreaction Hypothesis.  Using CAPM expected rates of return and comparisons of 31 lawsuit firms’ straddle returns, three new straddle trading strategies are devised.  Within the sample of lawsuits, abnormal returns are evident for the three strategies.  The results and their implications support behavioral finance and the Overreaction Hypothesis and thus refute the Efficient Markets Hypothesis.