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Effects of Earnings Releases on Option Prices?

| | Posted in: Equity Options

Reader Jeff Partlow asked and wondered: “Are you aware of research on the before and after impacts of company earnings releases on option prices? As a covered calls investor, I have gone back and forth about whether the increased option premiums available prior to earnings release makes it more advantageous to: (1) sell options prior to earnings release to take advantage of elevated premiums; or, (2) avoid companies with an impending earnings release to avoid the risk of negative earnings surprises.”

Here are some relevant studies from a Social Science Research Network search that includes the following keywords: earnings announcements options. Much of this research appears to focus on how options trading foreshadows earnings announcement content rather than how earnings announcements affect options trading.

“Options and Earnings Announcements: An Empirical Study of Volatility, Trading Volume, Open Interest and Liquidity”:

“In this paper we study the impact of earnings announcements on trading volume, open interest and spreads in the stock option market. We find that option volume is higher around announcement days, even if we correct for stock volume and the expected future volatility of stock returns. Results in the pre-event period are different for good and bad news samples, indicating that option traders have access to (possibly short lived) private information. During the days before the announcements open interest tends to increase. After the earnings¬†news dissemination traders seem to lose interest in the contracts and cancel part of their option positions thereby reducing open interest to normal levels. Analysis of quoted spreads provide no evidence of dealers’ anticipation of higher information asymmetry in the pre- or post announcement period. However, results for effective spreads indicate that the transaction costs are higher on the announcement day itself and on the day immediately following the earnings dissemination. Both quoted and effective spreads are shown to respond to changes in trading volume and expected return variability.” [Paper not available for download.]

“Options Trading Volume and Stock Price Response to Earnings Announcements”:

“We examine the effect of options trading volume on the stock price response to earnings announcements over the period 1996-2007. Contrary to prior studies, we find no significant difference in the immediate stock price response to earnings information announcements between firms with listed options and firms without listed options. However, within the sample of firms with listed options, we find that higher options trading volume reduces the immediate stock price response to earnings announcements. This is consistent with evidence that the stock prices of high options trading volume firms have anticipated and pre-empted some earnings information in the pre-announcement period. We also find that abnormal options trading volume around earnings announcements hastens the stock price adjustment to earnings news. We present evidence that post-earnings announcement drift is lower for stocks of firms with high abnormal options trading volume around earnings announcements.”

“The Option Market’s Anticipation of Information Content in Earnings Announcements”:

“This paper connects research examining the informativeness of accounting earnings with research documenting the option market’s price discovery role in order to develop an ex ante approach to studying the information content of earnings announcements. Specifically, we argue that option market participants consider anticipated stock price volatility surrounding upcoming earnings announcements in determining option prices. One implication of this assertion is that option prices (normalized by earnings uncertainty) should be sensitive to the firm and economic variables that the extant earnings-information-content literature documents affect ex post stock price responses to earnings innovations. This hypothesis is supported in the data. Furthermore, we posit that the magnitude of the stock price reaction to earnings news is not independent of ownership structure and find that, ceteris paribus, the presence of institutional investors known for their willingness/ability to trade based on earnings¬†news increases the magnitude of the volatility built into option prices.”

“Option Trading, Price Discovery, and Earnings News Dissemination”:

“Option market activity increases by more than 10 percent in the four days before quarterly earnings announcements. We show that the direction of this pre-announcement trading foreshadows subsequent earnings news. Specifically, we find option traders initiate a greater proportion of long (short) positions immediately before good (bad) earnings news. Midquote returns to active-side option trades are positive during non-announcement 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 delta contracts. Collectively, the evidence shows option traders participate generally in price discovery (the incorporation of private information in price), and more specifically in the dissemination of earnings news.” [Paper not available for download.]

“O/S: The Relative Trading Activity in Options and Stock”:

“Relatively little is known about the trading volume in derivatives relative to the volume in underlying stocks. We study time-series properties and the determinants of the options/stock trading volume ratio (O/S) using a comprehensive cross-section and time-series of data on equities and their listed options. O/S is related to many intuitive determinants such as delta and trading costs, and it also varies with institutional holdings, analyst following, and analyst forecast dispersion. O/S is higher around earnings announcements (suggesting increased trading in the options market), and higher O/S predicts lower abnormal returns after the earnings announcement, suggesting that options trading improves market efficiency.”

There may be other studies from this search that would interest you.

Factors to consider appear to be: (1) before and after effects of earnings release on implied volatility; (2) before and after effects of earnings release on option bid-ask spread; and, (3) indications from stock and options trading before earnings release of whether the earnings news is likely to be good or bad.

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