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option Trading, Price Discovery,
and Earnings News Dissemination*
KAUSHIK I. AMIN, Vice President
Lehman Brothers
CHARLES M. C. LEE, Associate Professor
Cornell University
Abstract
Option market activity increases by more than 10 percent in the four days
before quarterly earnings announcements. We show that the direction of this prean-
nouncement trading foreshadows subsequent earnings news. Specifically, we find
option traders initiate a greater proportion of long (short) positions immediately before
good ( bad ) earnings news. M idqu ote returns to active-side option trades are po si-
tive during nonannouncement periods and are significantly higher immediately prior to
earnings announcements. Bid-ask spreads for options widen during the announcement
period, but traders do not gravitate toward high deita contracts. Collectively, the evi-
dence shows option traders participate generally in price discovery (the incorporation of
private information in price), and more specifically in the dissemination of earnings
news.
Condense
La valeur economique d'un titre de placement veritable provient, en partie, de sa qual-
ite d'instrument efficient, susceptible de permettre l'int^gration de l'information priv-
ilegiee dans les cours. Les contrats d'options sur actions, par exemple, sont des actifs
superflus en ce sens que leurs rendements peuvent etre reproduits de fa90n dynamique
grace a un portefeuille d'obligations et d'actions sans risque du capital-actions sous-
jacent. Toutefois, ainsi que Grossman en fait l'observation (1988, p. 275), le principe
voulant qu'un vrai titre soit superflu lorsqu'il peut etre synthetise grace a une strategie
de negociation dynamique ne tient pas compte du role informationnel des titres v6rita-
bles.
Si les options sur actions peuvent parfois offrir une solution de rechange h moin-
dre cout aux negociateurs disposant d'information privilegi6e, il est probable que les
marches d'options ameliorent I'efficience des cours des marches d'actions. Ce role
informationnel contribue a la valeur dconomique des options sur actions.
Les auteurs analysent ici le role informationnel de la negociation d'options dans la
formation des cours (l'int^gration de l'information privilegi6e dans les cours) et dans la
diffusion de l'information relative aux benefices. Jusqu'& maintenant, les chercheurs se
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154 Contemporary Accounting Research
sont intdresses aux r6percussions des marches d'options en analysant les reactions des
marches d'actions a I'information relative aux bendfices, compte tenu de
Vexistence
de
march6s d'options'. Un theme revient constamment dans ces 6tudes : l 'existence d'un
march6 d'options semble etre associ6e a une hausse de la rentabilitd du march6 des
actions. Pour les entreprises dont les options se negocient, l 'ajustement du cours des
actions est plus rapide (Jennings et Starks, 1986), les reactions du cours a rinformation
relative aux b6nefices sont plus moderees (Skinner, 1990 ; Ho, 1993), et les glissements
du cours qui suivent les annonces sont moins prononces (Botosan et Skinner, 1993).
Si Ton en juge par ces observations, la negociation d'options contribue
h
I'effi-
cience globale des cours. Toutefois, ces etudes ne nous renseignent pas sur les m6can-
ismes de cette contribution. En se concentrant strictement sur les activites du march6
relatives aux actions sous-jacentes, les chercheurs ne s'interrogent pas sur le role de la
negociation d'options dans la diffusion de I'information et la formation des cours. La
mdthode propos6e ici est diff6rente du fait que les auteurs n'utilisent pas l'existence
d'un march6 d'options comme variable conditionnelle. Ils examinent plutot directement
les activitds de ndgociation d'options. Ils 6tudient plus pr6cis6ment le volume, le sens et
la rentabilitd des operations sur options qui precedent et suivent imm^diatement la pub-
lication de diverses informations inattendues relatives aux b6n6fices qu'il s'agisse de
bonnes ou de m auvaises nou velles. A partir de donnees d6taillees relatives aux op erations,
tirees de la base de donnees de Berkeley sur les options, les auteurs reinvent deux faits
nouveaux qui donnent
k
penser que les marches d'options ont un role informationnel.
Premierement, les auteurs constatent que le volume des op6rations sur les marches
d'option s augmen te plusieurs jours avant les annonces de b6n6fices. C ontrairement a ce
que Ton observe sur les marches d'actions, oil les n6gociations ne commencent a s 'in-
tensifier q u'au mom ent de l 'ann onc e, le volume des op6rations sur options grimpe de 10
a 15 pour cent jusqu'a quatre jours avant une annonce de benefices. Comme sur les
marches d'actions, l 'activite relative aux options demeure superieure ^ la normale pen-
dant plusieurs jou rs apres l'an no nc e. Toutefois, en con trolant 1'intensification simu l-
tan6e de la n6gociation d'actions. Ton constate que l'intensite de l'activite sur le marchfi
des options est disproportionnee seulement dans les trois ou quatre jours
qui preceden
la publication d'information relative aux benefices. Le moment de l 'annonce des b6n6-
fices 6tant previsible, ces observations donnent a penser que les n6gociateurs d'options
ajustent leurs positions en prevision de ces annonces-^.
Deuxiemement, les auteurs relevent certains faits demontrant que
1 intensity
accrue
des negociations sur les march6s d'options prealable aux annonces de b6n6fices n'est
pas uniquement le resultat de la reaction des negociateurs au risque de volatilit6. En
d'autres termes, les negociateurs d'options anticipent non seulement l 'ampleur du mou-
vement des cours (Patell et Wolfson, 1981), mais aussi la direction de ce mouvement.
Le plan de recherche adopte ici met a profit la precision des donn6es sectorielles pour
ddmontrer que la direction des operations sur options pr6alables aux annonces de
b6n6
fices presage du contenu de cette information. Plus pr6cis6ment, les auteurs notent une
plus grande proportion de positions acheteur (vendeur) adoptees par les n6gociateurs
instigateurs des operations immediatement avant la diffusion de bonnes (mauvaises
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Option Trading, Price Discovery, and Eam ings News Dissemination 155
Les auteurs font une troisieme e onstatation relide au role de la ndgociation d op -
tions dans la formation des cours (I integration de l informa tion privil6giee dans les
cours). Ils examinent plus precisement la sensibilite du cours des options et des actions
a Torientation que prennent les operations sur options qui entrent. Les Etudes recentes
sur la microstructure des marche s mo ntrent que, dans les march6s d ac tion s, les ope ra-
tions lancees l instigation de l ache teur (du vendeur) tendent etre suivies de revi-
sions
la hausse (a la baisse) de la cote. Ces mouvements sont la consequence naturelle
des couts des choix ddfavorables, les mainteneurs de marche ajustant leurs offres pour
tenir compte de l inform ation priviiegiee qui transparait dans les operations sur options
qui en tren t . Si les march es d op tion s jouen t un role dans la formation des cou rs, le
cours des op tions (et, par 1 intermediaire de l arbitra ge, le cours des a ctions s ous-
jacentes) reagira done a la direction des operations sur options qui entrent. En termes
precis, les operations sur options lancees a l instiga tion de l ach eteu r (du v endeu r)
devraient preceder des hausses (des baisses) du cours. Inversement, si la formation des
cours ne s applique qu au marche des actions, les cotes sur le marche des options seront
exclusivement fixees en reaction aux mouvements des cotes sur le marche des actions,
et la direction q ue prennen t les operations sur options qui entrent n offrira aucun pou-
voir predictif des rendements ultedeurs.
Pour evaluer I incide nce de l inform ation relative aux benefices, les auteurs co m-
parent le rendement au cours moyen pour l instigateur de la negociation d options, pen-
dant les annonces de benefices et pendant les pseudo-annonces d un echantillon cor-
respondant. Pour chaque annonce veritable, une pseudo-annonce provenant de la meme
entreprise est produite a la meme heure, mais
une date aleatoire. Les rendements
enregistres par les instigateurs des negociations relatives a 50 operations precedant et
suivant immediatement les annonces vedtables sont ensuite compares aux rendements
des operations correspondantes entourant les pseudo-anno nces. A l aide d un e strategie
de negociation simple, les auteurs ouvrent des positions fondees sur la direction achat
ou vente des operations sur options et les liquident au terme de la seconde journee de
negociation suivant I annon ce (ou la pseu do-annonce ).
Les auteurs constatent que les operations des instigateurs realisees au cours moyen
produisent des rendements
court terme de 1,5 a 3 pour cent pour les pedodes de pseu-
do-annon ce. Ce resultat donne a penser que les negociateurs d option s participent la
formation d es cours, mem e durant les pe do de s oij aucune an nonc e n es t publiee*. Les
auteurs constatent, en outre, que ces rendements sont beaucoup plus eieves pendant les
annonces de benefices. Les operations sur options lancees immediatement avant les
annonces de benefices ont des rendements, fondes sur le cours moyen, de 2 a 5 pour cent
a la fin du deuxifeme jou r suivant la date donnee , soit environ deux fois le rendem ent des
operations autour des pseudo-annonces correspondantes. Si ces operations sur options
avaient ete executees sur le marche des actions, moyennant le cours de la demiere
operation sur actions, les negociateurs auraient enregistre un rendement moyen plus
faible (mais toujours statistiquement significatif) de 0,2 pour cent. Ces constatations
montrent que les negociateurs d option s foumissent au marche de l information priv-
iiegiee, aussi bien pendant les pedod es d anno nce que pendant les pedod es oil aucune
annonce n est publiee.
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156 Contemporary Accounting Research
les contrats
k
delta eieve tendent a etre associes a des negociations moins intenses, ce qui
limite l itnportan ce de la position q ue les nego ciateurs renseignes peuvent prendre et aug-
mente la probab ilite de d etection. Dan s le choix d un contrat parmi ceux qui s offrent il
eux, les negoc iateurs informes doivent don e faire un comp romis entre les avantages d un
effet de levier plus grand, d un e part, et les couts sup ede urs des ecarts entre cours
acheteur et vendeur et le risque de detection, d autre part.
Conformement aux etudes recentes du m arche des actions a I interieur d un e
journee (par exemple. Lee, Mucklow et Ready, 1993), les auteurs constatent que les
ecarts efficaces entre cours acheteu r et vende ur sur les contrats d op tion s augm entent
durant les periodes d anno nces de benefices. Toutefois, I incidence econom ique de cette
augmentation est faible (les ecarts efficaces entre cours acheteur et vendeur sont de
5 pour cent plus eieves), et elle se concentre principalement dans la pedode posterieure
a I anno nce. C e resultat suggere une breve augm entation du risque d asym etrie de T in-
formation dans la pedode qui suit immediatement la publication des benefices*. De plus,
les auteurs ne relevent aucun fait etablissant que la valeur absolue des deltas soit
superieure dans les operations qui ont lieu a proximite des annonces. En fait, le delta
absolu moyen des operations qui ont lieu
h
proximite des annonces est legerement
inf ri ur
a la norm ale, en particulier dans la ped od e qui precede I anno nce. L on
peut en deduire, tout compte fait, que les negociateurs informes peuvent etre plus preoc-
cup es par la discretion d e leurs operations q ue par l obte ntion d effets de levier plus
importants.
Dans leur ensemble, les constatations des auteurs donnent a penser que les negoci-
ateurs d op tion s participent de faon ge nerale au processus de formation des cours en
gen eral, et, en particulier, a la diffusion de l inform ation relative aux be nefices. Les
etudes antedeures realisees sur les donnees relatives au marche des actions supposent
que I existence des m arches d option s favodse l efficience du cours des actions en ce
qui a trait il l inform ation relative aux ben efices. Les au teurs etablissent sans am bage s
que cette amelioration est attribuable a l inform ation priviiegiee que les neg ociateurs
d op tion s foum issent au marche. Leurs constatations suggferent notamm ent que certains
negociateurs d option s disposent d information pertinente aux cours relative aux
annonces de benefices a venir.
Les resultats de cette etude endc hissent egalement la somm e des connaissances sur
le lien intermarche entre actions et options. Les travaux recents nous laissent perplexes
quant h la rapidite du transfert de l informa tion entre les marches d op tion s et les
marches d actions (par exemple, Stephan et Whaley, 1990, et Chan, Chung et Johnson,
1993). Ils font appel aux tests de causalite Granger-Sims, sans condition relative h un
signal d inform ation exo gen e. Dans la presente etude, au contraire, les auteurs isolent
les activites de nego ciation an orm ales qui se rattachent a un signal d inform ation connu
et qui denotent des negociations plus rapides et mieux eda iree s sur les marches d op -
tions.
Leurs conclusions donnent a penser que les operations du marche des options peu-
vent regir le ma rche des actions, au moins durant les pedo de s de diffusion d inform a-
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Option Trading, Priee Discovery, and Eam ings New s Dissemination 157
Par exemple, voir Skinner (1990), Ho (1993), Jennings et Starks (1986), Botosan
et Skinner (1993). Les etudes generales de
1 incidence
des produits deriv6s sur le
comportement du cours des actions presentent egalement un interet (par exemple,
Figlewsk i et Webh, 1993 ; Dam odaran et Subrahm anyam , 1992 ; et Skinner,
1989), de meme que les etudes du lien intermarche entre les options et les actions
(par exem ple, Stephan et W haley, 1990 ; Cha n, Chung et Johns on, 1993).
En utilisant les dates de publication anterieures, Kross et Schroeder, 1984,
montrent que plus de 80 pour cent des annonces de henefices se situent dans un
intervalle de trois jours par rapport a la date prevue. Les entretiens des auteurs
avec les interesses et les specialistes permettent de croire que les n6gociateurs
disposent meme souvent d information encore plus precise au sujet des dates de
publication.
Les auteurs definissent les positions acheteur et vendeur par rapport au titre sous-
jacent. Par exemple, I 'achat d'une option d'achat et la vente d'une option de
vente sont tous deux consideres comme des positions acheteur. Ils utilisent une
techniqu e an alogue a celle de Lee et Ready, 1991 , et de Harris, 1989, pour
determiner l 'instigateur de chaque operation c'est-a-dire qui, de l 'acheteur ou
du vendeur, lance l 'operation.
Fait a noter, les conclusions montrent que
cert ines
informations privilegiees sont
d'abord integrees dans les eours sur le marche des options. Le resultat ohtenu ici
touche a la question de savoir si les marches d'options, en moyenne, regissent les
marches d'actions, sans porter directement sur ce sujet (soit celui des etudes
ant6rieures de Battachary a, 1987 ; Anthony , 1988h ; Stephan et Wh aley, 1990 ;
Chan, Chung et Johnson, 1993).
Hash rouck, 1988, Lee et Ready, 199 1, et Petersen et
Umlauf,
1991 , rapportent ce
phenomene empirique sur les marches d'actions. Voir Glosten et Milgrom, 1985,
et Easley et O'Hara, 1987, pour des exemples de modeles structures dans le cadre
desquels cet effet peut etre ohserve.
Les rendements du marche des options a court terme dont il est question ici ne
doivent pas etre confondus avec les rendements realisables, ajustes pour tenir
compte du risque, comme dans Whaley et Cheung, 1982. Les tests ont ici pour
but de detecter les changements de direction dans le flux des ordres qui entrent.
Ils ne sont pas conjus pour offrir une estimation des rendements economiques
cordges pour tenir compte du risque.
Le delta d'une option (defini comme etant 3C/3S, ou C est le prix du contrat et S
le cours de 1 action) mesure la sensibilite du prix du contrat aux fluctuations du
cours de I'action sous-jacente. Les options d'achat ont des deltas positifs, tandis
que les options de vente ont des deltas negatifs.
Le modele typique d'asymetrie de l 'information (par exemple, Copeland et Galai,
1983,
et Glosten et Milgrom, 1985) suppose deux types de negociateurs : les
negociateurs informes et les negociateurs qui se confinent a la liquidite . Les
negociateurs informes negocient parce qu'ils disposent d'information privilegi6e
qui ne se reflete pas encore dans les cours, tandis que les negociateurs de
liquidite negocient pour des raisons autres que la possession d'une meilleure
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158 Contemporary Accounting Research
The economic value of a real security derives, in part, from its usefulness as a
cost-effective vehicle for iocorporatiog private ioformatioo ioto prices. Equity
optioo cootracts, for example, are reduodaot assets io the seose that their
returos cao be dyoamically replicated by a portfolio of riskless bonds and
shares of the underlying stock. However, as Grossman (1988, 275) observes,
the notion that a real security is redundant when it can be synthesized by a
dynam ic trading strategy ignores the informational role of real securities. If
equity options can sometimes provide a lower cost trading alternative for pri-
vately informed traders, it is likely that option markets will enhance the price
efficiency of equity markets. This informational role contributes to the eco-
nomic value of equity options.
This study investigates the informational role of option trading in price dis-
covery (the incorporation of private information in prices) and in the dissemi-
oatioo of earoiogs new s. Prior studies examioed the effect of optioo markets by
analyzing stock market reactions to earnings news, conditional on the avail
ability of option markets. ' A recurrent theme in these studies is that option
market availability appears to be associated with increased price efficiency in
the equity market. For firms with traded options, the stock price adjustment is
faster (Jennings aod Starks 1986), market price reactioos to earniogs oews are
smaller (Skiooer 1990; Ho 1993), and postannouncement price drifts are less
pronounced (Botosan and Skinner 1993).
These studies suggest that option trading contributes to overall price effi-
ciency. However, they do not examine how this contribution occurs. By focus-
ing solely 00 market activities io the uoderlyiog stock, these studies do oot
address the role of optioo tradiog io oews dissemioatioo aod price discovery.
The approach io this study differs in that we do oot use the existence of the
option market as a cooditiooiog variable. Instead, we examine option trading
activities directly. Specifically, we investigate the volume, directioo, aod
prof
itability of optioo trades immediately arouod the release of differeot earnings
news surprises that is, goo d and bad news earnin gs. Using detailed trans-
action data from the Berkeley Options database, we report new evideoce that
suggests an informational role for option markets.
First, we find that option-market trading volume increases several days
before earnings aooouocemeots. Io cootrast to equity markets, where abnormal
tradiog does oot begio until the aooouocemeot date, option volume is 10 to 15
percent higher up to four days before an earnings announcement. As in equity
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Option Trading, Price Discovery, and Eamings News Dissemination 159
traders anticipate not only the mag nitude of a price reaction (Patell and W olfson
1981), but also its direction. O ur research design exp loits the precision of trade-
by-trade data to show that the direction of preannouncement option trades fore-
shadows the earnings news. Specifically, we find a greater proportion of long
(short) positions initiated by active-side traders immediately before good (bad)
earnings news.^ This finding suggests that some traders have superior informa-
tion prior to earnings announcements. The directional volume of preannounce-
ment option trades contrasts with Lee (1992), who finds no evidence of
informed trading in the buy/sell imbalance of equity trades prior to earnings
announcements. Therefore, with Lee, our findings imply that
some
privately
informed traders may prefer to trade in the option (versus equity) market. ' '
Our third finding relates to the role of option trading in pri e dis overy
(i.e., the incorporation of private information into price). Specifically, we
examine the sensitivity of option and equity prices to the direction of incoming
option trades. Recent studies in market microstructure show that, in equity mar-
kets,
buyer-initiated (seller-initiated) trades tend to be followed by upward
(downward) revisions in the quoted price. These movements are a natural con-
sequence of adverse selection costs, because market makers adjust their quotes
to reflect the private information revealed in the incoming trades.^ If option
markets play a role in price discovery, then option prices (and, through arbi-
trage, prices of the underlying stock) will be responsive to the direction of
incoming option trades. Specifically, buyer-initiated (seller-initiated) option
trades should precede price increases (decreases). Conversely, if price discov-
ery occurs purely in the equity market, quote prices in the option market will
be set entirely in response to quote movements in the equity market, and the
direction of incoming option trades will have no predictive power for subse-
quent returns.
To assess the impact of earnings news, we compare the midquote return to
active-side option trading during earnings announcements and during a
matched sample of "pseudo-announcements." For each actual news announce-
ment, we generate a pseudo-announcement using the same firm and time of
day, but a random date. We then compare returns to active-side trading on the
50 trades immediately before and after the actual announcements to the returns
on the corresponding trades around pseudo-an nounc emen ts Using a simple
trading strategy, we open positions based on the buy or sell direction of option
trades and unwind them at the end of the second day of trading after the
announcement (or pseudo-announcement) .
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160 Contemporary Accounting Research
trades. If these option trades bad been exec uted in the equity m arket at the price
of the last stock trade, the traders would have received a lower (but still statis-
tically significant) average return of 0.2 percent. These findings show that
option traders bring private information to market, both during announcement
and nonannouncement periods.
Finally, we provide limited evidence for the effect of earnings news on
option bid-ask sprea ds and the types of contracts traded. Informed traders elect-
ing to trade via options face a menu of contracts. One conjecture is that these
traders migbt prefer contracts with greater absolute
deltas
because higher
delta
options offer higher leverage per dollar invested. However, as we show, high-
erdelta contracts also have wider bid-ask spreads. Moreover, higher delta con-
tracts tend to have lower trading activity, thus limiting the size of the position
informed traders can take and increasing the likelihood of detection. In choos-
ing among available contracts, informed traders must, therefore, trade off the
benefits of greater leverage against the higher costs from bid-ask spreads and
the risk of detection.
Consistent with recent intraday studies of the equity market (e.g.. Lee,
Mucklow, and Ready 1993), we find that effective bid-ask spreads on option
contracts increase during earnings announcement periods. However, the eco-
nomic effect of the increase is small (effective bid-ask spreads are 5 percent
higher) and is focused primarily in the postannouncement period. This result
suggests a brief increase in information asymmetry risk in the period immedi-
ately after the ea rnings re lease. ^ In addition, we find no evidence of higher
absolute deltas in announcement trades. In fact, the average absolute delta of
announcement trades is slightly
lower
tban normal, particularly in the prean-
nouncement period. This finding suggests tbat, on balance, informed traders
may be more concerned with disguising their trades than with obtaining greater
leverage.
In summary, this study provides new evidence on the role of option trad-
ing in price discovery and earnings news dissemination. We show that, when
option trading is available, the option market is an important vehicle for
response to earnings news. Moreover, we find that the buy/sell activities of
option traders bring private information to market, wbich is then impounded in
price. Collectively, our findings suggest that option traders participate in the
price discovery process in general, and in the dissemination of earnings news
in particular.
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162 Contemporary Accounting Research
Do option traders react to earnings news
Our first goal is to provide large sample evidence about the extent of option
trading associated with eamings news. Schachter (1988) shows that open inter-
est declines prior to earnings announcements, particularly for contracts whose
values are most sensitive to volatility. Because open interest measures only the
total number of contracts outstanding, it does not capture investor reaction
associated with earnings inform ation. Anthony (1988a) studies option trading
around earnings news and reports elevated activity levels up to 10 days before
earnings releases. However, he uses a sample of only 10 firms and does not
examine the direction of these trades in relation to earnings news. In this study,
we use a sample consisting of all firms cross-listed on the American or New
York Stock Exchange (AMEX or NYSE) and the Chicago Board of Options
Exchange (CBOE) to evaluate the extent of option trading around earnings
news releases. Because the option and equity markets are linked through arbi-
trage, we expect traders to use both markets in responding to earnings news.
The extant evidence on the relative speed of price and volume adjustment
across option and equity markets is mixed. Manaster and Rendleman (1982),
Battacharya (1987), and Anthony (1988b) suggest that the option market leads
the equity market. However, Stephan and Whaley (1990) raise questions about
the test design of these studies. Using intraday data and the Granger (1969) and
Sims (1972) causality test, Stephan and Whaley report that price changes and
volume in the equity market lead the option market by fifteen minutes or more.
Most recently, Chan et al. (1993) use midquote prices to show that quote
changes are approximately contemporaneous across the two markets.
In contrast to these earlier studies, we examine the relative timing of the
trading activity in the two markets by conditioning on a news event: the Broad
Tape release of quarterly earnings. The exogenous earnings signal, time
stamped to the nearest minute, allows us to isolate the abnormal trading activ-
ity in the two markets. This research design allows us to compare the relative
timing and direction of the volume reactions in the equity and option markets,
with a view towards understanding the different roles played by each in infor-
mation dissemination.'^
We hypothesize that volume reaction in the option market will lead equity
volume reaction for two reasons. First, option traders anticipate earnings
announcements and adjust their position in anticipation of increased volatility.
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Option Trading, Price Discovery, and Eam ings New s Dissem ination 163
Do option traders have advance knowledge of earnings news
To assess the extent of private information brought to market by option traders,
we examine the buying and selling activities of active-side option traders. The
optioo market on the CBOE is a continuous agency auction, in which compet-
ing market makers post tradable qu ote s. In this type of continuou s auction,
the active side of each trade is defined as the side that initiated the trade. We
use an algorithm similar to Harris (1989) aod Lee aod Ready (1991) to identi-
fy each trade as either buyer- or seller-initiated. We then classify option trades
as either long or short positions relative to the underlying stock. A long posi-
tion is the purchase of a call or the sale of a put option. A short position is the
purchase of a put or the sale of a call option. If initiators of option trades have
knowledge of forthcoming news, we expect to observe a greater proportion of
long (short) position trades immediately before good (bad) news.
Several studies suggest that certain traders may have foreknowledge of
earnings news, obtained through information leaks (Seppi 1992; Seyhun 1992)
or increased information collection activities (Kim and Verrecchia 1991). In
particular, the buy/sell direction of both block trades (Seppi) and of insider
trades (Seyhun) anticipates earnings news. However, Lee (1992) finds that, on
average, the buy/sell imbalance of equity trades immediately before earnings
annouocemeots does not foreshadow upcomiog oews. We apply Lee s approach
to option data. If informed traders gravitate to option markets before earnings
announcements, we should observe a higher proportion of long (short) posi-
tions taken before good (bad) oews.
Are prices responsive to option trades
A secood method of assessiog the ioformatioo value of optioo trades is by
studyiog the profitability of such trades. Earlier studies based oo the Black-
Scholes model suggest that optioos markets may oot be perfectly price efficieot
(e.g., Galai 1977, 1978). However, later studies show that after traosactioo
costs,
it is difficult to make systematic aboormal returos by tradiog options. In
particular, Phillips and Smith (1980) identify the bid-ask spread as the largest
cost facing option traders. Phillips and Smith show that quoted spreads on
optioos are 6 to 10 percent of the contract price, whereas quoted spreads on
stocks are typically less than 1 percen t of the stock pric e. ^ If market ma kers
set sufficiently wide spreads in options, option traders will not, on average,
make abnormal tradiog profits.
The fiodiog that spreads are wider for optioo contracts thao for stocks is
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164 Contemporary Accounting Research
of choice for informed traders when concurrent trading is available in options
and equities. In equilibrium, they find that both informed and liquidity traders
divide their trades between the option and equity markets. However, their
model does not address the pattern of informed trading immediately before an
information event. In theory, market makers should respond to increased infor-
mation asymmetry risk by widening spreads prior to an anticipated earnings
relea se, ^ but unless the timing of the event is fully anticipated, m arket ma kers
are unlikely to set sufficiently wide spreads to deter all informed trading.
Consequently, informed traders may still find an advantage in preannounce-
ment trading.
In sum, informed traders confront a trade-off in choosing between trading
venues. They need to balance the higher liquidity costs of the option market
against the greater leverage it offers. On the one hand, options are more costly
per unit of (ie/?a-adjusted position; on the other hand, far fewer contracts are
needed to participate in an anticipated price m ove. Ultimately, the decision may
hinge on the likelihood of detection. If informed traders can sometimes obtain
a greater lie/fa-adjusted position (or action) in options before detection, we
should expect to observe
som
informed trading in options. Earnings news
releases offer an attractive setting for exam ining this question, becau se the like-
lihood of an imminent price move increases the payoff to informed trading.
ata and samp le selection
The firms for this study were selected from the Institute for the Study of
Security Markets (ISSM) and the Berkeley Options (CBOE) databases for 1988
and 1989. The ISSM data contain trade and quote information for all NY SE and
AMEX firms, whereas the CBOE data contains similar information for option
contracts on firms listed at the Chicago Board of Options Exchange. A total of
147 firms were listed for the two full years on both the CBOE and the ISSM
tapes. Of these firms, three were utilities with regulated earnings of limited
interest to traders; two firms were offshore ADRs (Hanson PLC and Hitachi
Ltd. ADR); and one was Student Loan Marketing, for which only nonvoting
shares are traded. Eliminating these six firms resulted in a final sample of 141
firms, rep resenting all cross-listed firms on the two m arkets over the study pe ri-
od. These firms are listed in Appendix 1. Except for three AMEX companies
(AMH, FRX, PLL), all our sample firms are listed on the NYSE.
The CBOE data contain all option trades and quote revisions, time stamped
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Option Trading, Price Discovery, and Eamings News Dissemination 165
minutes after the New York market closes. Our study period predates the large
scale multiple-listing of options on several exchanges. Therefore, with the
exception of four firms, our dataset captures the entire options volume for each
firm.'9
We obtained the intraday time of earnings announcements for our sample
firms from the
ow Jones News Retrieval Service
(DJNS, or Broad Tape). All
quarterly earnings announcements were identified for our sample of 141 firms.
The DJNS news release provides the time of the release to the nearest minute.
In the case of multiple releases of the same earnings news, we select the first
release after the fiscal quarter end. Because the DJNS begins each day around
6:45 a.m. CST and continues until approximately 5:45 p.m. CST, an announce-
me nt may occur before the option m arket opens or after it closes. For our daily
analysis, we categorize announcements made when the CBOE is closed (here-
after, overnight announcements) as arriving immediately before opening the
next day.
In some of our tests, we use the Value Line Investment Survey forecast of
quarterly earnings per share (EPS) from issue immediately preceding the
announcement date to proxy for market expectat ions about earnings.
Announcements in which the actual reported EPS exceed the Value Line fore-
cast are identified as goo d new s, whe reas those where actual EPS is lower
than the Value Line forecast are bad new s. To ensure EPS is calculated con-
sistently, we checked the reported EPS from the DJNS against the actual EPS
from the Value Line issue immediately after the announcement. In the few
cases the EPSs do not match, we use the Value Line figure.
Although all 141 firms are cross-listed, several firms had little option trad-
ing volume. To reduce outliers caused by skewed nonannouncement reference
distributions, we require firms to meet minimal levels of option trading activi-
ty. Specifically, in our daily analyses, we required that firms have an average
of at least one option trade per day, eliminating nine firms from the sample.
sults
aily volume ana lyses
To evaluate trading volume reaction to earnings news across the two markets,
we first document the daily abnormal trading in each market. Figure 1 reports
the daily abnormal trading volume in the market for the underlying stock, as
well as in call and put options. For this analysis, the event window is the 21
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166 Contemporary Accounting Research
Figure 1Abn ormal trading volum e around the release of earnings
2
I
f
60-
50-
40-
30-
20-
10-
0 .
-10-
-20-
Panel
A:
Abnormal trading in equity market
I I I
Panel B:
Abnormal trading in call options
60-
50.
'40-
30-
20.
10-
0 .
-10-
-20-
Panel C: Abnormal trading in put options
-ff
l t
I I I
Date relative to announcement of eamings news
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Option Trading, Price Discovery, and Eamings News Dissemination 167
the trading volume in stocks is approximately 35 percent higher than normal.
The magnitude of this increase is comparable to volume increases found for
large firms in earlier studies e.g.. Lee 1992; and Bam ber 1986, t98 7) .
Consistent with prior work, we find that trading volume in the stock market
remains high for over a week after the earnings news release. Also consistent
with prior results, we find little evidence of increased stock trading in the days
immediately prior to the DJNS announcement.
In Figure t, panels B and C report the abnormal volume reaction to earn-
ings news in call and put contracts. These figures show that option trading
increases around the release of earnings information. As with the stock market
reaction, the abnormal vo lume in options is mo st pronoun ced on Day 0 and Day
+t, when abnormal option volume is also approximately 35 percent higher than
normal. These findings support the hypothesis that option markets provide
traders with an alternative vehicle for responding to earnings announcements.
In Figure t, the most striking difference between the stock and option vol-
ume reactions occurs in the days leading up to the announcement. For both call
and put options, we find increased levels of trading at least three days before
the anno unce m ent. This finding is consistent with Anthony t9 88 a) , who finds
that option trading volume increases as early as 10 days before earnings
announcements. The increased preannouncement volume may reflect specula-
tion based on expectations of higher volatility, the closing out of positions by
risk-averse investors, or informed trading. We examine reasons for the
increased preannouncement volume in our intraday analyses.
Because trading across the option and equity markets is contemporaneous-
ly correlated, we examine option market volume reaction after controlling for
stock volum e. We present the results of this analysis in Table 1. The depe nden t
variables for these regressions are the daily number of trades in either calls
CTrd) or puts PTrd)P The independ ent variables are the daily num ber of
stock trades STrd)and stock shares SVol)transacted, as well as indicator vari-
ables for the 13 trading days around qua rterly earnings a nnou ncem ents. All vol-
ume measures are expressed as percentage deviations from nonevent period
means. Models t and 2 regress option volume on the event indicator variables;
M odels 3 and 4 regress
CTrd
or
PTrd
on the stock volum e va riables; and M odels
5 and 6 combine both event period indicators and stock volume variables.
Regressing option volume on stock volume results in adjusted R2S of 42.3
percent and 16.6 percent for call volume and put volume, respectively. These
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168 Contem porary Accounting R esearch
60
c
a
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o
3
a
a
i
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IS
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Option Trading, Price Discovery, and Eamings News Dissemination i69
trades should be correlated with the earnings news. As a first test of this
hypothesis, we compute the proportion of long and short positions taken on the
options traded immediately around the release of earnings news. We define
long and short positions in terms of the underlying stock. Therefore, a long
position is the purchase of a call or the sale of a put option, whereas a short
position is the purchase of a put or the sale of a call option. If initiators of
option trades have advance knowledge of earnings news, we should observe a
greater proportion of long (short) position trades immediately before good
(bad) news announcements.
To implement this test, we use an algorithm for classifying option trades
into buyer- and seller-initiated transactions. Similar to Harris (1989) and Lee
and Ready (1991), we infer the buy/sell direction of each trade by comparing
the trade price to the prevailing quote prices for the given option contract. We
classify each trade as buyer-initiated if it is closer to the ask price, and seller-
initiated if it is closer to the bid price. Trades that are exactly at the midpoint
of the prevailing spread (midspread trades) are considered indeterminable in
direction and are excluded . Lee and Ready use a tick test, based on prior
price changes, to classify midspread trades in their study of equity trading.
However, because trading in a given option contract is much less frequent than
it is in a stock, the tick test is not as reliable for option markets. Moreover, our
preliminary tests indicate that midspread trades are far less frequent in options,
so the advantage of the tick test for this study is minimal.
Table 2 reports the frequency and proportion of long and short positions
taken in the option market immediately before and after earnings releases. For
this analysis, good (bad) news events are those in which the actual reported
earnings are greater (less) than the most recent Value Line forecast.
Announcements with no Value Line forecast, or with actual earnings equal to
forecasted earnings, are excluded. ong positions are buyer-initiated calls or
seller-initiated puts; short positions are seller-initiated calls or buyer-initiated
puts.
To simplify the table, we report trades in groups of 10. We include all
trades classifiable as buys and sells between the beginning of trading on Day
-2 and the end of trading on Day +2.^' Each announcement also is limited to
the 50 trades immediately before and after the DJNS news release time. Panel
A reports the results in transaction time, with trades reported in groups of ten.
Panel B reports the results in clock time, with trades grouped in two-hour trad-
ing intervals around the DJNS release time.
Consistent with Vijh (1988), Table 2 shows a greater proportion of long
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170 Contemporary Accounting Research
of option trades foreshadows the sign of the earnings news surp rise, as prox-
ied by the Value Line forecast error.
TABLE 2
Long and short positions taken in option contracts around earnings news that either
exceed (good news) or are less than (bad news) the most recent Value Line earnings
forecast*
Panel A: Results
Timing of trade
relative to DJNS
announcement
-5 0 to -4 t
- 4 0 t o - 3 1
- 3 0 t o - 2 1
- 2 0 t o - 1 1
- l O t o - 1
Total pre-
announcement
+
to +10
+ t o + 2 0
+21 to+30
+31 to +40
+41 to +50
> in transaction time
Good
Long
positions
827
992
1167
1228
1470
5684
1485
1365
1246
1197
1043
(50 trades)
news earnings
Short
positions
706
774
893
1022
1290
4685
1445
1121
997
848
815
Percent
long
53.9
56.2
56.7
54.6
53.3
54.8
50.7
54.9
55.6
58.5
56.1
Bad
Long
positions
871
tO15
1035
1234
1536
5691
1632
1476
1310
U 4 1
1004
news earnings
Short
positions
723
771
970
1083
1461
5008
1452
1103
989
966
976
Percent
long
54.6
56.8
51.6
53.3
51.3
53.2
52.9
57.2
57.0
54.2
50.7
Difference
stat)
-0 .36
-0 .34
+3.21
+0.89
+ 1.51
2.36
-1 . 7 0
-1 .64
-0 .96
+2.82
+3.37
Total post-
announcement
6336 5226 54.8 6563 5486
54.5 0.51
Panel B:
Results in clock time (two-hour trading intervals)
Good news earnings Bad news earnings
Clock time Long
relative to positions
announcement
< -8 hours
- 8 to - 6 hours
- 6 to - 4 hours
- 4 to - 2 hours
-2 hrs to -1 min.
Total pre-
235
34 9
672
1071
3357
5684
Short
positions
209
308
602
839
2727
4685
Percent
long
52.9
53.1
52.7
56.1
55.2
54.8
Long
positions
226
311
637
1053
3464
5691
Short
positions
221
313
613
904
2957
5008
Percent
long
50.6
49.8
51.0
53.8
53.9
53.2
Difference
stat)
+0.67
1.12
+0.88
+ 1.39
+ 1.37
2.36
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Option Trading, Price Discovery, and Eam ings New s Dissem ination 171
* This table reports the frequency and propo rtion of long and short position s taken in the option
market immediately before and after good and bad news earnings releases.Long positions are
buyer-initiated calls or seller-initiated puts;short positions are seller-initiated calls or buyer-
initiated puts.
Good bad) news events
are those in which the actual reported earning is greater
less) than the most recent Value Line forecast. Announcement times are obtained from the
Dow Jones New s Service DJN S), and all trades classifiable as buys or sells and execu ted
within two trading days of the DJNS release time are included. Panel A reports results in
transaction tim e for the 50 trades imm ediately around the release time), and Panel B reports
results in clock time in 2-hour trading intervals around the release time ). The
z
statistics are
based on a chi-squared test of the null hypothesis that the long and short positions taken are
uncorrelated with the earnings signal.
The proportion of long positions in postannouncement trades is not signif
icantly different for the good news and bad news samples. This finding is con-
sistent with prior evide nce e.g.. Le e 1992 and Patell and Wolfson 1984) that
prices adjust to the new equilibrium quickly. Using the postannouncement pro-
portions as a benchmark, most of the directional shift in preannouncement vol-
ume appears to derive from an increase in the proportion of short positions
taken before bad news announcements. Panel B realigns these trades by clock
time. This panel shows that the increase in short position before bad news grad-
ually occurs over the two trading days prior to the DJNS news release.
The Value Line forecast error provides an exogenous measure of the earn-
ings surprise that is independent ofthe price formation process. However, there
are several potential problems witb this approach. First, these forecasts can be
noisy proxies for market expectations at the time of the announcement. These
forecasts are often s tale issued up to seven w eeks earlier) and may not reflect
more current information, including voluntary preannouncement disclosures,
which appeared after the forecasts. Therefore, conditioning on the Value Line
forecast error may introduce noise about the nature of the news event, making
informed trading more difficult to detect. Second, the DJNS announcement
time may not be precisely aligned with CBOE trading times. If earnings news
is publicly available to option traders before the DJNS time stamp. Table 2
findings may not represent privately informed option trading.
TABLE 3
Classification of earnings announcements*
Good news
Good
news
224
Value ine
Bad
news
209
Neutral
news
24
Total
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172 Contemporary Accounting Research
reported earning is greater (less) than the most recent Value Line forecast. When the Value
Line forecast is missing or when the reported earnings is equal to the Value Line forecast, the
event is classified as neutral news. Under the price change method, good bad) news events
are those in which the price change from the midpoint of the quote at the time of the annou nce-
ment to the end of Day +2 is positive (negative). Neutral news pertains to events with zero
price change. Table values represent the number of announcements in each category.
Table 3 reports the join t frequency distribution of earnings anno unce m ents
classified as good or bad news using the sign of the Value Line forecast error
and the sign of the price change from the time of the announcement to the end
of trading on Day +2. The results in this table show that although the two clas-
sification methods yield positively correlated results, they are far from being
identical. In 406 ann ounce m ents (over 40 perce nt). Value Line s good (bad)
news classification conflicts with the actual price change during the announce-
ment period.
As an alternative to Value Line forecast errors, we use the sign of the two-
day price change
after
the DJNS announcement to classify announcements as
good (bad) news events. This method eliminates the concern that some firms
may release voluntary preannouncement information. Because the prean-
nouncement trades in our study take place
before
the subsequent price move,
this method also eliminates the concern that the price-relevant news was pub-
licly known prior to the preannouncement trades.
TABLE 4
Long and short positions taken in option contracts around earnings news that result in
either a positive return (good news) or negative return (bad news)*
Panel A: Results in transaction time (50 trades)
Good news earnings Bad news earnings
Timing of trade
relative to DJNS
announcement
- 5 0 t o - 4 1
-40 to -31
- 3 0 t o - 2 1
- 2 0 t o - 1 1
- l O t o - 1
Total pre-
Long
positions
892
1026
1095
1285
1517
5815
Short
positions
675
717
904
986
1 2 7 2
4554
Percent
long
56.9
58.9
54.8
56.6
54.4
56.1
Long
positions
111
947
1069
1136
1414
5343
Short
positions
693
768
921
1096
1460
4938
Percent
long
52.9
55.2
53.7
50.9
49.2
52.0
Difference
{istat)
+2.23
+2.16
+0.67
+3.83
+3.88
+5.92
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Option Trading, Price Discovery,
and
Eamings News Dissemination
173
TABLE4cont d.
Panel
B:
Results
in
clock time (two-hour trading intervals)
Good news earnings
Bad
news earnings
Clock time
relativeto
announcement
+8
hours
Total post
announcement
Long
positions
188
372
619
1107
3529
5815
3798
1054
556
459
510
6377
Short
positions
228
330
576
782
2 6 3 8
4554
2917
969
572
481
555
5494
Percent
long
45.2
53.0
5L8
58.6
57.2
56.1
56.6
52.1
49.3
48.8
47.9
53.7
Long
positions
283
294
682
938
3 1 4 6
5343
3634
951
599
472
458
6114
Short
positions
224
288
617
896
2 9 1 3
4938
2744
914
544
348
484
5034
Percent
long
55.8
50.5
52.5
51.1
51.9
52.0
56.9
51.0
52.4
57.6
48.6
54.8
Difference
{ stat)
-3.18
+0.84
-0.32
+4.55
+5.89
5.92
-0.46
+0.67
-1.43
-3.64
-0.27
1.69
* This table reports the frequency and prop ortion
of
long and short positions taken
in
the o ption
market immediately before and after good and bad news earnings releases.Long positionsare
buyer-initiated callsor seller-initiated puts;
short positions
are seller-initiated callsorbuyer-
initiated puts.Good bad) news events are thoseinwhich the actual equ ity m arket return from
the announcement time tothe endofDay +2ispositive negative). The timesofthe ann ounce-
ments are obtained from the Dow Jones New s Service DJN S). All transactions classifiableas
buys or sells are included provid ed they areexecuted within twotrading days of the
announcement time. Panel
A
reports results
in
transaction time
(for
50 trades imm ediately
around therelease time),andPanelB reports results inclock time (in 2-hour trading inter-
vals). Thezstatisticsarebasedonachi-squared testof the null hy pothe sis that thelongand
short positions taken areunco rrelated w ith sign returns asso ciated w iththeannouncement.
In Table 4, we present an analysis of directional volume for good and bad
news announcements, as classified by the actual two-day price change. When
announcements are partitioned on the basis of the actual price change, we find
a greater difference between good and bad news samples. Once again, a greater
proportion of long positions are taken before good news, than before bad news.
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174 Contemporary Accounting Research
immediately prior to the DJNS news release, we find once again evidence that
the direction of option trades anticipate the subsequent price move.
Although Table 4 results suggest that active-side option trades anticipate
the nature of earnings news, these results may be limited by two design issues.
First, the chi-squared statistics may be biased upwards if option trades are pos-
itively and serially correlated, that is, long (short) positions tend to follow long
(short) positions. Second, active-side trades may anticipate future price moves
even when no earnings news is announced, tf option prices are sensitive to
order imbalances, then the Table 4 results may not be related to earnings infor-
mation. We address these issues in the next section through the use of a pseu-
do-announcement methodology.
Trading profits
tn addition to examining the direction of option trades, we also examine their
profitability. The main purpose of these tests is to evaluate the extent to which
option traders participate in price discovery, tf option traders bring private
information to market, then the direction of active-side option trades will antic-
ipate subsequent price movements. This movement will yield short-run profits
to active-side option trades, that is, when option traders initiate buys (sells),
prices are more likely to move up (dow n). Conversely, if option trades bring no
new information to market, then buys and sells in the option market arrive ran-
domly and active-side option trading will not be profitable.
To compute trading profits, we assume the active-side of each trade and
assess the profits under three different trading strategies, tn the first strategy,
we comp ute the midspread return MsRet), that is, we assess the information
content of buys and sells by assuming that positions can be taken at the aver-
age of the bid and ask price (midspread price) at the time of the trade. Thus, we
compute returns using the midspread price at the time of the trade and the mid-
spread p rice at the end of Day +2 for that particula r contract, tn effect, we com -
pute the profit that the trade initiator would realize without paying the spread.
If traders are uninformed about upcoming price changes, then the expected
return computed from midspreads should be close to zero. Conversely, if trade
initiators are informed about future price changes, this strategy should yield a
positive return.
In the second strategy, we initiate the position at the actual trade price and
unwind at the bid (ask) price at the end of Day +2 for buys (sells). This strate-
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Option Trading, Price Discovery, and Earnings New s Dissetnination 175
position in the stock for purchases (sales) of calls, and a short (long) position
in the stock for purchases (sales) of puts. We then unwind the position at the
closing stock price at the end of Day +2 to com pute the equity return
EqRet).
This trading rule mimics the returns an option trader would receive in the equi-
ty market. B ecause the last equity trade co uld be e ither a buy or a sell, the e qui-
ty return does not include the cost of the bid-ask spread. Thus,
EqRet
is com-
parable toMsRet in the option market. However, consistently positive EqRets
would suggest the information in incoming option trades is not yet reflected in
the equity market.
In our analysis of trading profits, 3,228 trades (around seven percent)
involve contracts that expire on or before Day +2. These trades do not have
closing quotes two days after the announcement, so we substitute the value of
the contract at expiration for the closing quote price. Specifically, we compute
trading profits for these trades using the following option value at expiration:
Call Options: Max [S - X, 0]
Put Options: Max [X - S, 0]
whereX is the strike price of the contract and S is the stock price based on the
last trade on Day +2. Using this approach, we attribute the expiration value to
the contract at the end of Day +2.
TABLE 5
The profitability of option trades around earnings announcements*
Panel A:
Results in transaction time (50 trades)
Timing of
trade relative
to DJNS
event time
-50 to -41
- 4 0 t o - 3 1
- 3 0 t o - 2 1
- 2 0 t o - 1 1
Midspread
returns
No.
of
observations MsRet
(%)
3244
3697
4266
4775
2.82
5.88
4.39
5.22
rstat
3.14
6.01
4.64
5.77
Realizable
returns
e et
(%)
-9 .41
- 7 .6 8
-10 .08
-9 .66
tstat
10.5
8 .2
-11 .2
n .2
Equity
returns
q et
(%)
0.158
0.216
0.132
0.154
f stat
2.55
3.79
1.95
3.14
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176 Contemporary Accoutiting Research
TABLE5cont'd.
Panel
B Resultsinclock time (2-hour trading intervals)
Midspread
returns
Clock time
relativeto N o.of
announ observations
MsRet
cement
( )
+8hours
979
1364
2677
4015
12955
13936
4198
2408
1965
2181
1.70
2.51
4.11
5.28
4.50
2.60
2.68
4.02
0.77
1.86
tstat
1.02
1.76
4.00
6.03
8.53
5.14
3.43
3.80
0.76
1.90
Realizable
returns
t
( )
-18.01
-14.62
-11.84
-10.39
-8.33
-11.15
-13.62
-12.76
-16.52
-15.72
tstat
-11.31
-11.08
-12.01
-11.73
-16.45
-22.66
-17.97
-12.68
-16.68
-18.07
Equity
returns
EqRet
( )
0.087
0.122
0.195
0.250
0.129
0.141
0.035
0.109
-0.085
-0.118
f
stat
0.88
1.40
3.13
3.70
4.11
5.01
0.83
1.14
-1.64
-1.20
* This table reportstheaverage return s obtaine d from takingthe active side
of
option trades
immediately before and after the releaseofearnin gs new s. Results using three different trad-
ing rulesarereported.
MsRet
istheaverage midspread returnpertrade, assuming tradesare
madeatthe m iddleof the bid-ask spread. For option buys(orsells),along(orshort) contract
positionisestablishedatthe m iddleof the prevailing spreadatthe timeofthe actual trade and
unwound attheclosing midspread priceon Day +2. Theavera ge realizable return ReRet)
incorporates thebid-ask spread,sothat buys sells)areestablished atthe actual trade price
and unwoundattheclosingbid ask) priceon Day+2 .Theaverag e equ ity return EqRet)is
computed usingthestock pricein theequity marketat thetimeof the option trade.Foreach
option trade,acorresponding long(orshort) positionistakenin theequity market usingthe
last equity trade price
and
unwoundat
the
last equity trade price
on Day
+2 .
All
returns
are
expressed
in
percent. The times
of
the announcem ents are obtained from the Dow Jones N ews
Service DJNS).All transactions classifiable asbuysorsellsare included, provided theyare
executed within two trading daysof the anno uncem ent time. Panel A reports resultsintrans-
action time 50 trades),andPanelB reports resultsinclock time 2-hour trading intervals).
The
t
statistics
are
based
on
a
test
of
the null hypothesis that
the
avera ge return
is
not
signif
icantly different from zero.
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Option Trading, Price Discovery, and Eam ings New s Dissem ination 177
the days a round the ea rn ings r e l ease . In con t r as t , t he ReRet resu l t s show tha t
a l though in i t i a to r s o f op t ion t r ades may an t i c ipa te the p r i ce move , h igh b id -ask
spreads in the op t ion marke t make such t r ades unprof i t ab le .
T b e
ReRet
resu l t sugg es t s tba t ac t ive - s ide op t ion t r ader s do no t m ak e
abnormal p ro f i t s . However , i t does no t imply tha t t r ader s a r e i r r a t iona l fo r
choos ing to t r ade op t ions . To assess whe ther these t r ader s behave r a t iona l ly
( i .e . ,
op t imal ly ) , we need more in fo rmat ion abou t cos t s and benef i t s fo r com-
parab le t r ades in the s tock marke t . Moreover , we no te tha t approx imate ly one-
th i rd of the opt ion t rades have posi t ive
ReRets.
For these t r ader s , t he op t ion
s t r a t egy p roved p ro f i t ab le even a f t e r b id -ask sp reads .
T h e
EqRet
resu l t s show tha t , i gnor ing b id -ask sp re ads , t r ades exec u ted in
the equ i ty marke t a l so y ie ld pos i t ive r e tu rns . The
t
sta t i s t ics on
EqRets
a re
lower than for
MsRet
but s t i l l s ta t i s t ica l ly s igni f icant . This resul t shows tbat
the in fo rmat ion b rough t to marke t by ac t ive - s ide t r ader s was no t ye t impound-
ed in tbe s tock pr ice a t the t ime of the opt ion t rade. Table 5 sbows that
EqRets
are mucb smal l e r than
MsRets.
T h e a v e r a g e
EqRet
f or p r e a n n o u n c e m e n t o p t io n
t r ades i s on ly a rou nd 16 bas i s po in t s , co m par ed to 40 0 to 500 bas i s po in t s for
MsRet.
Thi s d if f e rence r e f l ec ts the g rea te r l everage ava i l ab le in the op t ion ma r -
ket , as wel l as the greater r i sk borne by opt ion t raders .
A s m e n t i o n e d p r e v i o u s l y ,
MsRet
resu l ts ma y not be a t t r ib utab le sole ly to
the r e l ease o f ea rn ings ne w s . P r io r s tud ies (e .g . , H asb rou ck 198 8 ; Lee and
Re ady 19 91 ; and Pe te r se n and Um lauf 1991) hav e show n tha t the ac t ive - s ide
of each t r ade fo resha dow s sub seq uen t p r i ce m ov es , tha t i s , buy er ( se l l e r ) in i t i -
a t ed t r ades t end to be fo l lowed by inc reases (decreases ) in s tock p r i ces . Th i s
pa t t e rn r e f l ec t s the adver se se lec t ion p rob lem faced by marke t maker s . Because
marke t maker s a r e r e l a t ive ly un in fo rmed , they in fe r the a r r iva l o f in fo rmat ion
f rom incoming ac t ive - s ide o rder s . Spec i f i ca l ly , tbey r espond to buyer - in i t i a t ed
t r ades by moving the p r i ce up and to se l l e r - in i t i a t ed t r ades by moving the p r i ce
down. I f op t ion t r ader s b r ing p r iva te in fo rmat ion to marke t , a pos i t ive
MsRet
r esu l t s even when no ea rn ings news i s r e l eased .
To compare the p ro f i t ab i l i ty o f ac t ive - s ide t r ades in even t and noneven t
p e r i o d s , w e g e n e r a t e a s a m p l e o f p s e u d o - a n n o u n c e m e n t s . F o r e a c h
a n n o u n c e m e n t i n o u r s a m p l e , w e c re a t e a p se u d o - a n n o u n c e m e n t b y r e t a i n i n g
the sam e t ime o f day and r ando m ly d raw ing a da te d i s t r ibu t ion o f non an-
n o u n c e m e n t d a t e s f o r t h e s a m e f i r m . F o r e a c h p se u d o - a n n o u n c e m e n t , w e a l so
draw the neares t 50 t r ades imm edia te ly be fo re and a ft e r the an no un cem en t t im e
(prov ided these t r ades t ake p lace a f t e r the open ing o f t r ad ing on Day -2 and
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178 Contemporary Accounting Research
news release. Table 6 shows that the averageMsRetduring nonannouncement
periods is approximately two percent. In comparison, the midspread-to-mid-
spread return on option trades during announcement periods(MsRetin Table 5)
is over four or five percent, approximately twice as large. The higher
prof
itability of active-side trades around the earnings release date is consistent with
option traders establishing positions with foreknowledge of earnings news.
TABLE
6
The profitability
of
option trades around randomly selected pseudo-announcement
dates*
Timing
of
trade relative
to JNS
event time
-50 to
^ 1
-40 to-31
-30 to-21
-20
to -11
-lOto-1
+1 to+10
+11 to+20
+21 to+30
+31
to
+40
+41to +50
No.of
Midspread
returns
observations
MsRet
2970
3312
3892
4833
5973
6163
5084
4381
3888
3457
( )
0.591
1.665
0.346
2.416
2.998
0.236
0.193
2.447
1.928
L564
f
stat
0.76
2.11
0.47
2.73
4.36
0.44
0.35
4.03
2.99
2.13
Realizable
returns
ReRet
( )
-n .49
-11.14
-12.73
-12.23
-12.45
-16.18
-14.90
-12.15
-12.15
-11.87
tstat
15.1
14.8
17.7
15.5
-18.8
-29.8
-26.8
-20.6
-19.2
-16.9
Equity
returns
EqRet
( )
-0.118
0.039
-0.027
-0.016
-0.005
-0.065
-0.116
0.029
0.260
-0.406
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Option Trading, Price Discovery,andEamings News Dissemination 179
TABLE
7
Abnormal profitability
of
option trades around earnings releases after controlling
for
matched-sample pseudo-announcements*
Timing
of
trade relative
to DJNS
event time
-50 to-41
-40 to-31
-30 to-21
-20 to-11
- lOto -1
+1to+10
+11 to+20
+21
to +30
+31to +40
+41 to+50
No of
Midspread
returns
observations sRet
1589
2626
3442
4156
5484
5734
4568
4047
3134
2030
( )
1.76
2.73
2.74
2.45
1.51
3.04
3.85
-0.43
-1.30
-0.29
tstat
1.11
1.86
1.94
1.85
1.56
3.41
3.76
-0.38
1.00
-0.23
Realizable
returns
ReRet
( )
1.79
2.47
2.13
2.06
1.85
3.11
3.55
-0.73
-1.54
-0.46
tstat
1.14
1.76
1.59
1.71
1.96
3.46
3.59
-0.69
-1.20
-0.36
Equity
returns
q et
( )
0.220
0.198
0.112
0.112
0.121
0.239
0.269
0.214
-0.11
0.109
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180 Contemporary Accounting Research
Interestingly, the results for the realizable returns ReRet) are also statisti-
cally significant and similar in magnitude. Because the difference between
these two columns is due solely to changes in the quoted spread during event
periods, these results imply that quoted spreads increase only marginally dur-
ing the announcement period. The equity return EqRet) shows that the infor-
mation advantage in option trades can also be detected using equity trade
prices. During the preannouncement period, EqRet is marginally higher than
normal. However, the strongest information effect comes from the 10 trades
immediately after the announcement. These trades realize an average return of
0.24 percent t statistic=4.34) over two days.
Bid-ask spreads and absolute deltas
As a final test, we compare the composition of contracts traded in announce-
ment periods to those in matching pseudo-announcements. Specifically, we
focus on changes in the bid-ask spreads and absolute
deltas
for contracts trad-
ed during the announcement. As discussed previously, bid-ask spreads should
increase if information asymmetry risk (the risk of trading with an informed
trader) increases around earnings releases. The average absolute delta should
also increase for announcement trades if informed traders prefer option con-
tracts that provide greater leverage.
Table 8 reports summary statistics on the effective spread and absolute
deltas for all announcement trades and their matching pseudo-announcement
trades. The two variables in this table are as follows;
Sprd
effective spread = 2
TradePrice -
Midspreadl,
and
I A
= absolute delta -
dC/dS I.
In these definitions, the effective spread for each contract
Sprd)
is two
times the absolute difference between the trade price and the midpoint of the
quoted bid and ask prices at the time of the trade Midspread), expressed in dol-
lars. The absolutedelta for each contrac t (I A I) me asures the sensitivity of the
contract price (C) to changes in the stock price (5). The option valuation pro-
cedures followed to compute each contrac t s
delta
and implied volatility are
described in Appendix 2.
Table 8 shows that, during nonannouncement periods, the average effective
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Option Trading, Price Discovery,andEarnings News Dissemination 181
TABLE
8
Effective hid-ask spreads
and
contract deltas during earnings announcements*
Panel A:Effective bid-ask
No.
oftrades
Mean
Median
t statistic
Pseudo
spreads Sprd)
announcement Announcement period
trades
58041
0.158
0.130
Aggregate
60656
0.163
0.130
7.05
Preannouncement
28564
0.159
0.130
0.55
trades
Postannouncement
32092
0.166
0.130
11.08
Panel
B:Absolute contractdeltas Delta)
Pseudo
announcement
trades
Announcement period trades
No.of
observations
Mean
Median
t
statistic
58041
0.518
0.485
Aggregate
60656
0.515
0.476
-2.80
Preannouncement
28564
0.513
0.469
-4.34
Postannouncement
32092
0.517
0.483
-0.67
* This table reports
the
average effective spread Sprd)
and the
average absolute contract delta
.Delta)
for
option contracts traded immediately around earnings announcem ents
and
match-
ing pseudo-announcements. A pseudo-announcement has
the
sam e firm
and
time
of
day
as an
actual announcement,
but is
based
ona
randomly selected no nannouncem ent date. A trade
is
included
in
the
table
if it is
among
the 50
trades executed imm ediately before
or
after each
announcement
(or
pseudo-announcement), provided it isalso within
two
trading daysof
the
DJNS announcement
(or
pseudo-anno uncem ent) time. Effective spread Sprd)
for
each trade
is defined
astwo
times
the
absolute difference between
the
trade price
and the
midpoint
of
the quoted
ask and bid
prices
at the
time
of
the trade, expressed
in
dollars
per
share. The
con-
tract delta Delta), defined
as
3C/3S, measures
the
sensitivity
of
each contract s price
to its
stock price. Because calls have positivedeltas
and
puts have negative deltas. Panel
B
reports
the average absolute delta.
The
/statistics
are
based
on
atestofthe null h ypoth esis that
the
mean Sprd
or
Delta
for
announcement trades
isnot
significa ntly different from
the
mean
for
pseudo-announcements.
Panel B of Table 8 shows that the average absolute
delta
of traded contracts
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182 Contemporary Accounting Research
of 15 percent in the price of contracts traded during nonannouncement periods.
The small 0.3 percent decrease in elasticity suggests that option traders do not
forego much leverage by choosing lower delt (i.e., lower elasticity) contracts
during earnings announcements. As discussed previously, informed traders may
be concerned with revealing their intentions and adversely affecting prices. In
addition, contracts with higher absolute
delt s
have wider effective spreads.^
The results in Table 8 suggest that these costs outweigh the potential benefits
of trading in higher leverage contracts.
on lusion
This study investigates the abnormal trading volume in option markets around
the announcement of earnings news. For firms with listed options, we find that
a significant portion of the overall reaction in trading volum e takes place in the
option market. As with equity trading, this abnormal reaction is most pro-
nounced on Day 0 relative to the DJNS report. During this date, call option vol-
ume is 35 percent and put option volume is 55 percent higher than normal. As
in the equity market, this abnormal option activity persists for several days.
However, after controlling for contemporaneous trading in the equity market,
abnormal option volume is observed only in the three to four days before th e
quarterly earnings announcement.
We also investigate the extent to which option traders incorporate private
information into prices. Earlier studies suggest that informed traders may pre-
fer the cost structure in option markets. Consistent with this hypothesis, we
find that the buy/sell activities of option trades foreshadow subsequent earn-
ings news. Moreover, we document positive midquote returns to active-side
option trades, suggesting that initiators of option trades bring private informa-
tion to market. After controlling for transaction costs, we show that the
prof
itability of active-side option trading increases during earnings announcements.
This increase implies that at least some of the private information brought to
market is earnings-related.
We observe a small increase in the effective bid-ask spread for options
traded around the earnings announcement. However, we find no evidence that
traders during the event period prefer higher-leverage contracts. In fact, the
average absolute
delt
of announcement trades is slightly lower than for pseu-
do-announcement trades. We suggest wider bid-ask spreads and strategic con-
cerns (related to the premature revelation of their intentions) may deter
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Option Trading, Pdce Discovery,
and
Eam ings New s D issemination
183
Our f ind ings a l so con t r ibu te to the l i t e ra tu re on the i n t e r mar ke t l i nkage
be t ween s t ocksandop t i ons . R ecen t ev i den ceon thes peedofin forma t ion t r ans -
fe r be tween op t ion
and
equ i t y m ar ke t s
has
been mixed e .g . , S teph an
and
W h a l e y 1990 and C h a n et al 1993) . T hes e s t ud i e s emp l oy Gr an ge r - S i m s
causa l i ty t es t s , wi thout condi t ion ing on an exo geno us i n f o r ma t i on s i gna l. In
cont ras t , wei so la te abn orm al t r ad ing ac t iv i t ies tha t r e la te to a know n i n f o rma-
t ion s ignal and show fas ter and mo re in formed t r ad ing in the op t i on mar ke t .
Our ev idence sugges t s tha t op t ion marke t t r ades l ead theequ i ty ma rke t , at l eas t
du r i ng pe r i ods of ea r n i ngs news d i s s emi na t i on .
These f ind ings imply anecon om i c r o l efor theop t ion m arke tas a cos t -ef f i -
c i en t mechan i s m
for
p r i ce d i scovery .
As
s ugges t ed
by
G r o s s m a n 1 9 8 8 ) ,
op t i onsare notme re ly r edu nda nt s ecur i t i es tha tcan besubs t i tu ted by d y n a m i c
t rad ing s t r a teg ies in s tocks and bonds . R a t he r , our r esu l t s on the s peed and
di rec t ion
of
op t ion t r ades sup por t
the
v iew tha t som e in formed t r ader s
are led
first to the op t ion m arke t . In this sense, the opt io n m ark et of fers a l ow- cos t
m e a n s for i m p o u n d i n g newin forma t ion in to p r i ces .
A p p e n d i x
L i s tof 4 sample f irms
22249
4476
2635
28 76
26874
268 4
239 5
3 897
3 9 5
325
48825
543 3
258 6
97 23
66 5
7 8 3
7 43
L
AGC
GE
IG
IT
AMH
MP
N
PC
RC
VP
XP
BA
C
X
C
ALUMINUM CO AMERICA
ALEXANDER ALEXANDER SER
AMER GEN CORP
A G EDWARDS INC
AMERIINTL GROUP INC
AMERIINEORMATION TECH CO
AMDAHL CORP
AMP INC
AMOCO CORP
ANADARKO PETROLEUM CORP
ATLANTIC RICHFIELD CO
AVON PRODUCTS INC
AMERICAN EXPRESS COMPANY
BOEING CO
BANKAMERICA CORPORATION
BAXTER INTERNATIONAL INC
BRUNSWICK CORP
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184 Contemporary Accounting Research
12189710
08750910
07390210
17119610
20491210
12484510
13985910
19121910
17303410
17052010
21236310
19044110
15852510
12550910
19416210
20536310
24736110
25365110
26353410
25384910
25468710
26054310
26188510
29284510
27746110
27805810
34537010
31330910
31818110
34386110
31945510
34583810
35671410
BNI
BS
BSC
C
CA
CBS
CCB
CCE
CCI
CCN
CDA
CG P
CHA
CI
CL
CSC
DAL
DBD
DD
DEC
DIS
DOW
DRY
EC
EK
ETN
F
FDX
FFC
FLR
ENB
FRX
FTX
BURLINGTON NORTHERN INC
BETHLEHEM STEEL CORP
BEAR STEARNS COMPANIES INC
CHRYSLER CORP
COMPUTER ASSOC INTL INC
CBS INC
CAPITAL CITIES /ABC INC
COCA COLA ENTERPRISES INC
CITICORP
CHRIS CRAFT INDUSTRIES INC
CON TROL DATA CORP
COASTAL CORP
CHAMPION INTERNATIONAL CORP
CIGNA CORP
COLGATE PALMOLIVE CO
COMPUTER SCIENCES CORP
DELTA AIR LINES INC DEL
DIEBOLD INC
DU PONT DE NEMOURS E I CO
DIGITAL EQUIPMENT CORP
DISNEY WALT COMPANY
DOW CHEMICAL CO
DREYFUS CORP
ENGELHARD CORP
EASTMAN KODAK CO
EATON CORP
FORD MOTOR CO
FEDERAL EXPRESS CORP
FIREMANS FUND CORP
FLUOR CORP
FIRST CHICAGO CORP
FORES