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. Midquote returns to active-side option trades are posi- 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 * Accepted by Lane Daley. The authors thank Charles Jones for providing research assistance. James Myers, John O'Brien, Paul Seguin, Doug Skinner, Amy Sweeney, Robert Whaley, two anonymous referees, and workshop participants at Laval University, Massachusetts Institute of Technology, the University of Michigan, University of Southern California, Vanderbullt University, and the University of Waterloo all provided helpful comments. Lee is grateful for financial support from the KPMG Peat Marwick Foundation and the University of Michigan Sanford R. Robertson Professorship Fund. Contemporary Accounting Research Vol. 14 No. 2 (Summer 1997) pp. 153-192 ©CAAA 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 mauvaises nouvelles. A partir de donnees d6taillees relatives aux operations, 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'options augmente plusieurs jours avant les annonces de b6n6fices. Contrairement a ce que Ton observe sur les marches d'actions, oil les n6gociations ne commencent a s'in- tensifier qu'au moment de l'annonce, 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 jours apres l'annonce. Toutefois, en controlant 1'intensification simul- 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 precedent 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) nouvelles relatives aux b6nefices^. Cette constatation donne k penser que certains n6go- ciateurs disposent d'information de qualite sup6rieure prealablement aux annonces de b6n6fices. Ces observations relatives au volume directionnel des op6rations sur options pr6alables aux annonces different des conclusions de Lee (1992) qui ne voit aucune preuve de l'existence de negociations informees dans le d6sequilibre achat/vente des op6rations sur actions avant les annonces de benefices. C'est pourquoi, avec celles de Lee (1992), les conclusions des auteurs permettent de supposer que certains n6gocia- teurs disposant d'information privilegi6e preferent n^gocier sur le march^ des options (plutot que le marche des actions)". Option Trading, Price Discovery, and Eamings News Dissemination 155 Les auteurs font une troisieme eonstatation relide au role de la ndgociation d'op- tions dans la formation des cours (I'integration de l'information 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 marches montrent que, dans les march6s d'actions, les opera- tions lancees h l'instigation de l'acheteur (du vendeur) tendent h etre suivies de revi- sions h 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'information priviiegiee qui transparait dans les operations sur options qui entrent'. Si les marches d'options jouent un role dans la formation des cours, le cours des options (et, par 1'intermediaire de l'arbitrage, le cours des actions sous- jacentes) reagira done a la direction des operations sur options qui entrent. En termes precis, les operations sur options lancees a l'instigation de l'acheteur (du vendeur) 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 que prennent les operations sur options qui entrent n'offrira aucun pou- voir predictif des rendements ultedeurs. Pour evaluer I'incidence de l'information relative aux benefices, les auteurs com- 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 h 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-annonces. A l'aide d'une 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'annonce (ou la pseudo-annonce). Les auteurs constatent que les operations des instigateurs realisees au cours moyen produisent des rendements h court terme de 1,5 a 3 pour cent pour les pedodes de pseu- do-annonce. Ce resultat donne a penser que les negociateurs d'options participent h la formation des cours, meme durant les pedodes oij aucune annonce n'est 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 jour suivant la date donnee, soit environ deux fois le rendement 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'options foumissent au marche de l'information priv- iiegiee, aussi bien pendant les pedodes d'annonce que pendant les pedodes oil aucune annonce n'est publiee. Enfin, peu de faits temoignent de I'incidence de l'information relative aux benefices sur les ecarts entre cours acheteur et vendeur des options et sur la nature des contrats negocies. Les negociateurs informes qui preferent negocier des options ont & choisir parmi un grand nombre de contrats. Une hypothese veut que ces negociateurs pourraient preferer des contrats presentant des « deltas » absolus plus grands, parce que les options ayant des deltas supedeurs offrent un effet de levier plus eieve par dollar investi'. Toutefois, ainsi que le demontrent les auteurs, les contrats qui presentent un delta plus affichent egalement des ecarts plus grands entre cours acheteur et vendeur. De plus. 156 Contemporary Accounting Research les contrats k delta eieve tendent a etre associes a des negociations moins intenses, ce qui limite l'itnportance de la position que les negociateurs renseignes peuvent prendre et aug- mente la probabilite de detection. Dans le choix d'un contrat parmi ceux qui s'offrent il eux, les negociateurs informes doivent done faire un compromis entre les avantages d'un effet de levier plus grand, d'une part, et les couts supedeurs des ecarts entre cours acheteur et vendeur et le risque de detection, d'autre part. Conformement aux etudes recentes du marche des actions a I'interieur d'une journee (par exemple. Lee, Mucklow et Ready, 1993), les auteurs constatent que les ecarts efficaces entre cours acheteur et vendeur sur les contrats d'options augmentent durant les periodes d'annonces de benefices. Toutefois, I'incidence economique 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'annonce. Ce resultat suggere une breve augmentation du risque d'asymetrie de Tin- 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 inferieur a la normale, en particulier dans la pedode qui precede I'annonce. L'on peut en deduire, tout compte fait, que les negociateurs informes peuvent etre plus preoc- cupes par la discretion de leurs operations que par l'obtention d'effets de levier plus importants. Dans leur ensemble, les constatations des auteurs donnent a penser que les negoci- ateurs d'options participent de fa§on generale au processus de formation des cours en general, et, en particulier, a la diffusion de l'information relative aux benefices. Les etudes antedeures realisees sur les donnees relatives au marche des actions supposent que I'existence des marches d'options favodse l'efficience du cours des actions en ce qui a trait il l'information relative aux benefices. Les auteurs etablissent sans ambages que cette amelioration est attribuable a l'information priviiegiee que les negociateurs d'options foumissent au marche. Leurs constatations suggferent notamment que certains negociateurs d'options disposent d'information pertinente aux cours relative aux annonces de benefices a venir. Les resultats de cette etude endchissent egalement la somme des connaissances sur le lien intermarche entre actions et options. Les travaux recents nous laissent perplexes quant h la rapidite du transfert de l'information entre les marches d'options 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'information exogene. Dans la presente etude, au contraire, les auteurs isolent les activites de negociation anormales qui se rattachent a un signal d'information connu et qui denotent des negociations plus rapides et mieux edairees sur les marches d'op- tions. Leurs conclusions donnent a penser que les operations du marche des options peu- vent regir le marche des actions, au moins durant les pedodes de diffusion d'informa- tion relative aux benefices. Ces conclusions attribuent un role economique au marche des options & titre de mecanisme efficient de formation des cours. Comme le suggere Grossman (1988), les options ne sont pas simplement des titres superflus auxquels peuvent se substituer des strategies dynamiques de negociation d'actions et d'obligations. Les resultats de la presente etude en ce qui a trait h la vitesse et a la direction des operations sur options vont plutot dans le sens de l'opinion selon laquelle certains negociateurs informes sont d'abord interesses par le marche des options. En ce sens, le marche des options offre un moyen economique d'integrer l'information nouvelle dans les cours. Option Trading, Priee Discovery, and Eamings News 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, Figlewski et Webh, 1993 ; Damodaran et Subrahmanyam, 1992 ; et Skinner, 1989), de meme que les etudes du lien intermarche entre les options et les actions (par exemple, Stephan et Whaley, 1990 ; Chan, Chung et Johnson, 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 technique analogue 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 certaines 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 Battacharya, 1987 ; Anthony, 1988h ; Stephan et Whaley, 1990 ; Chan, Chung et Johnson, 1993). Hashrouck, 1988, Lee et Ready, 1991, 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 information. Les mainteneurs de marche soutiennent les pertes decoulant de la negociation avec des negociateurs informes, et ils recuperent ees pertes grace aux ecarts entre cours acheteur et vendeur. Selon ces modeles, plus l'asymetrie de l'information est grande entre les negociateurs informes et les negociateurs de liquidite, plus les ecarts sont grands. Toujours selon ces modeles, l'asymetrie du risque lie a l'information peut augmenter avec une hausse dans la proportion des negociateurs qui sont informes ou une augmentation de la precision de leur information. 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 dynamic 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 news. 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, "good" and "bad" news earnings. 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 markets, options activity remains higher thao normal for several days after the anoouocemeot. However, cootrolling for contemporaneous increases in equity trading, we find that option market activity is disproportionately high only in the three to four days before the earnings news release. Because the timing of earnings news announcements is predictable, our findings suggest that optioo traders adjust their positions io aoticipatioo of these aooouocemeots.'^ Secoodly, we fiod some evideoce that iocreased preaonouncement option trading reflects more than trader response to volatility risk. That is, option Option Trading, Price Discovery, and Eamings News Dissemination 159 traders anticipate not only the magnitude of a price reaction (Patell and Wolfson 1981), but also its direction. Our research design exploits 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 price discovery (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-announcements! 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). We find that active-side trades executed at midquote prices generate short- term returns of 1.5 to 3 percent for pseudo-announcement periods. This result suggests that option traders participate in price discovery even during nonan- nouncement periods.^ Furthermore, we find that these returns are significantly higher during earnings announcements. Option trades initiated immediately before earnings announcements have midquote returns of 2 to 5 percent by the end of Day +2, about twice the return on corresponding pseudo-announcement 160 Contemporary Accounting Research trades. If these option trades bad been executed in the equity market 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 spreads 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- er delta 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 earnings release. ^ 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. The remainder of the paper is organized as follows. The next section reviews related papers and formulates the hypotheses. The third section describes the sample and data used. Section 4 reports results of the empirical tests. The final section summarizes our findings and their implications. Development of hypotheses Stock options are derivative financial contracts tbat offer potentially reduced transaction costs and increased financial leverage, relative to trading the under- Option Trading, Price Discovery, and Eamings News Dissemination 161 lying stock. A call (put) option gives its owner the right to buy (sell) a fixed number of shares of a specified stock at a fixed price at any time on or before a given date. The return patterns of option contracts can be replicated by a dynamically adjusted portfolio of riskless bonds and shares of the underlying stock. Therefore, option contracts and shares of the underlying stock differ mainly in terms of their transaction costs. With concurrent trading in essential- ly redundant assets, investors should gravitate toward the market with lower overall costs.' Many authors (e.g.. Black 1975; Cox and Rubinstein 1985; Manaster and Rendleman 1982; and Skinner 1990) have argued that privately informed traders may prefer the cost structure in the option market,'" that is, relative to trading in the underlying equity, option traders may find more favorable implic- it borrowing rates, lower margin requirements, and less stringent restrictions on short-selling (both in terms of the Uptick Rule in equity markets and the inter- est on the proceeds of short-selling). Moreover, some information, such as that related to future volatility of stock prices, can be more easily exploited in the option market. For traders with private information and wealth constraints, these differences translate into greater leverage per dollar invested. In particu- lar, traders with short-lived information about upcoming news events may pre- fer the option market. An alternative view is that option markets are informationally redundant, that is, prices in option markets are purely a by-product of price discovery activities in the stock market. This view finds expression in Stephan and Whaley (1990), who report that, on average, stock option transaction price changes occur 15 or 20 minutes after stock price changes. Chan, Chung, and Johnson (1993) verify the Stephan and Whaley results and then go on to docu- ment that, when stock option bid/ask midpoints are used, the markets' price changes appear simultaneous. One interpretation of these findings is that option markets are highly illiquid and costly relative to the stock market; hence, infor- mation trading takes place in the stock market where transaction costs (and the likelihood of detection) may be less. In this study, we investigate four issues related to the role of option trad- ing in the dissemination of earnings news. First, we document the extent and timing of option volume increases around the release of earnings news, that is, we examine the extent to which traders use the option market as an alternative vehicle of response to earnings news. Second, we use directional trading vol- ume (buy/sell activities) to examine whether option traders are better informed about earnings information than stock traders. Third, we evaluate the role of option trading in price discovery by studying the returns to initiators of option trades. Finally, we provide preliminary evidence on the types of contracts pre- ferred by informed traders. 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 information." 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. Earnings news are known to increase price volatility risk, which traders can manage using option contracts. Some traders may place speculative bets that cannot be implemented by trading in stocks, others may close out positions to avoid the announcement risk.'^ If volatility-plays increase prior to earnings announcements, then option volume will lead equity volume. Secondly, to cap- italize on their private information, better informed traders with capital con- straints may also gravitate toward the option market. We investigate both pos- sibilities. Option Trading, Price Discovery, and Eamings News Dissemination 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 quotes.''' In this type of continuous 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 percent of the stock price.'^ If market makers 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 coosisteot with the preseoce of more ioformed traders io the option market, that is, if options market makers face a greater risk of trading with informed traders than do their equity counterparts, bid-ask spreads should be wider in the option market.'* Faced with wider spreads in the option market, informed traders may choose to trade in the equity market instead. This tension between increased leverage and wider spreads is modeled by John, Koticha, and Subrahmanyam (1991). Their model examines the vehicle 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 release,'^ but unless the timing of the event is fully anticipated, market makers 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 trader