Amin and Lee (1997) - Option Trading , Price Discovery and Earnings News Dissemination

7/21/2019 Amin and Lee (1997) - Option Trading , Price Discovery and Earnings News Dissemination

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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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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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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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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.


9/41


10/41


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.


11/41

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


12/41


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


13/41


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


14/41


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


15/41


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


16/41

168 Contem porary Accounting R esearch

60

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a

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3

a

a

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en


17/41

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


18/41


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


19/41


* 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


20/41


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


21/41

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.


22/41


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-


23/41

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


24/41

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.


25/41


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


26/41


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


27/41

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


28/41


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


29/41

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


30/41


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


31/41

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


32/41


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

Amin and Lee (1997) - Option Trading , Price Discovery and Earnings News Dissemination

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Transcript of Amin and Lee (1997) - Option Trading , Price Discovery and Earnings News Dissemination