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 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 move. 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 some informed trading in options. Earnings news releases offer an attractive setting for examining this question, because the like- lihood of an imminent price move increases the payoff to informed trading. Data and sample 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 NYSE 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, representing all cross-listed firms on the two markets over the study peri- 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 to the nearest second. For each put or call traded, the database contains the time of execution, expiration date, strike price, trade price, and trade volume, as well as the stock price of the last equity trade at the time of option execution. Each quote revision contains the execution time, expiration date, strike price, bid and ask prices, and the concurrent stock price.'^ The Chicago Board of Options Exchange begins trading each day at 8:30 a.m. CST (9:30 a.m. EST) and con- cludes at 3:15 p.m. CST (4:15 p.m. EST). Option trading commences at the same time equity trading begins on the New York Stock Exchange and ends 15 Option Trading, Price Discovery, and Eamings News Dissemination 165 minutes after the New York market closes. Our study period predates the large scale multiple-listing of options on several exchanges. Therefore, with the exception of four firms, our dataset captures the entire options volume for each firm.'9 We obtained the intraday time of earnings announcements for our sample firms from the Dow 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- ment may occur before the option market 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 expectations about earnings. Announcements in which the actual reported EPS exceed the Value Line fore- cast are identified as "good" news, whereas those where actual EPS is lower than the Value Line forecast are "bad" news. 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. Results Daily volume analyses 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 days centered on the DJNS announcement date. Daily abnormal volume for each firm is defined as the actual daily volume (in contracts or shares traded), minus the mean daily volume for the firm from nonevent days, expressed as a percentage deviation from the nonevent period mean. The reported average abnormal trading volume is the daily abnormal volume averaged across all firms. We report results at 1, 5, and 10 percent significance levels, based on two-tailed cross-sectional t tests. 166 Contemporary Accounting Research Figure 1 Abnormal trading volume around the release of earnings Panel A: Abnormal trading in equity market 2 60- 50- I 40- 30- 20- 10- f 0. I I I -10- -20- Panel B: Abnormal trading in call options Panel C: Abnormal trading in put options 60- 50. '40- 30- 20. 10- 0. -ff l t 1 II I' -10- -20- Date relative to announcement of eamings news These graphs depict the abnormal trading volume around quarterly earnings news releases in the equity market, and in the market for call and put options. All firms cross-listed on the NYSE and the CBOE for both 1988 and 1989 are included. Abnormal trading is expressed as percentage deviation from the daily mean for each firm and averaged across all firms. Two-tailed significance levels: ^ 1 % ; ^ 5%; CD 10%. Figure 1, panel A, shows that the stock market volume reaction is focused on Day 0 and Day +1, relative to the DJNS announcement. On these two days. Option Trading, Price Discovery, and Eamings News Dissemination 167 the trading volume in stocks is approximately 35 percent higher than normal. The magnitude of this increase is comparable to volume increases found for large firms in earlier studies (e.g.. Lee 1992; and Bamber 1986, t987). 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 volume in options is most pronounced 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 announcement. This finding is consistent with Anthony (t988a), 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 volume. We present the results of this analysis in Table 1. The dependent variables for these regressions are the daily number of trades in either calls (CTrd) or puts (PTrd)P The independent variables are the daily number of stock trades (STrd) and stock shares (SVol) transacted, as well as indicator vari- ables for the 13 trading days around quarterly earnings announcements. 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; Models 3 and 4 regress CTrd or PTrd on the stock volume variables; and Models 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 results indicate that stock volume accounts for a significant portion of the daily variations in option market volume. Interestingly, controlling for the increase in stock volume, we find that the abnormal volume in options occurs primarily in the days before the DJNS news release (Models 5 and 6). On Days - 4 to - 2 , we observe unusually high option trading relative to the stock trading. Again, the evidence shows elevated levels of option trading immediately before earn- ings news. 168 Contemporary Accounting Research en CS en en r-; &2 S d d CN' CN vd •C u^ 3 i I" rt o en o rt d en d ^00 xi g X! is g § IS ON o 111' p OS o in T o q en Tt -a I o CN en 1 T3 O VO VO o o I « —' a\ VO •-- QN -— 4J aj S I "O ^H ra O Q CN •a ^ 2 ea VO CN q V en en en ^— VO O\ d 00 71 ra CS u-i rt go lO CN c 53 o .11 •§' od CN -a ^ D. c ^ Xt to •gs !1 CN en I:S| •2 .2 60 c 2 o en d 3 'S •?§ I I •a 00 o B OS a CS ' = •/, - g eg (D = 3 <N o es en Q u-i od o 3 S3 •a a. O\ ,2 S "^ •£ S § u 3 -^— u '*5 ti cs' o 8 8 2 O '-' < " crt c« C . , ^ rt fl) C ^ • ^ rt 3 3r O o •ft d C ta " eo 00 2 I « -3 -S I S " o --3 ^ :2 "3 -S ^ J E •fS.s pa a •O o 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. Long 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 positions for both good news and bad news announcements.^^ More important- ly, we find good news announcements are preceded by a greater percentage of long position option trades than are bad news announcements. Panel A shows that, before good news announcements, 54.8 percent of option trades are long positions, compared to 53.2 percent for bad news announcements. Statistically, the difference is significant at the 1 percent level in a two-tailed, chi-squared test {z statistic=2.36). The preannouncement result suggests that the direction 170 Contemporary Accounting Research of option trades foreshadows the sign of the earnings news "surprise," 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> in transaction time(±50 trades) Good news earnings Bad news earnings Timing of trade Long Short Percent Long Short Percent Difference relative to DJNS positions positions long positions positions long (z stat) announcement -50 to -4t 827 706 53.9 871 723 54.6 -0.36 -40 to-31 992 774 56.2 tO15 771 56.8 -0.34 -30 to-21 1167 893 56.7 1035 970 51.6 +3.21 -20 to-11 1228 1022 54.6 1234 1083 53.3 +0.89 -lOto-1 1470 1290 53.3 1536 1461 51.3 + 1.51 Total pre- 5684 4685 54.8 5691 5008 53.2 +2.36 announcement + 1 to +10 1485 1445 50.7 1632 1452 52.9 -1.70 + 11 to+20 1365 1121 54.9 1476 1103 57.2 -1.64 +21 to+30 1246 997 55.6 1310 989 57.0 -0.96 +31 to +40 1197 848 58.5 U41 966 54.2 +2.82 +41 to +50 1043 815 56.1 1004 976 50.7 +3.37 Total post- 6336 5226 54.8 6563 5486 54.5 +0.51 announcement Panel B: Results in clock time (two-hour trading intervals) Good news earnings Bad news earnings Clock time Long Short Percent Long Short Percent Difference relative to positions positions long positions positions long (z stat) announcement < -8 hours 235 209 52.9 226 221 50.6 +0.67 - 8 to - 6 hours 349 308 53.1 311 313 49.8 + 1.12 - 6 to - 4 hours 672 602 52.7 637 613 51.0 +0.88 - 4 to - 2 hours 1071 839 56.1 1053 904 53.8 + 1.39 - 2 hrs to -1 min. 3357 2727 55.2 3464 2957 53.9 + 1.37 Total pre- 5684 4685 54.8 5691 5008 53.2 +2.36 announcement +0 min. to +2 hrs 3722 2848 56.7 3887 2950 56.9 -0.21 +2 to +4 hours 1029 909 53.1 1066 1002 51.5 +0.95 +4 to +6 hours 536 488 52.3 650 604 51.8 +0.21 +6 to +8 hours 543 453 54.5 474 405 53.9 +0.23 > +8 hours 506 528 48.9 486 525 48.1 +0.35 Total post- 6336 5226 54.8 6563 5486 54.5 +0.51 announcement Option Trading, Price Discovery, and Eamings News Dissemination 171 * This table reports the frequency and proportion of long and short positions 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 News Service (DJNS), and all trades classifiable as buys or sells and executed within two trading days of the DJNS release time are included. Panel A reports results in transaction time (for the ±50 trades immediately 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 evidence (e.g.. Lee 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 stale (issued up to seven weeks 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* Value Line Good Bad Neutral Total news news news Good news 224 209 24 457 Price Bad news 197 249 21 467 change Neutral news 46 40 5 91 Total 467 498 50 1015 This table reports the joint frequency distribution of earnings announcements classified as good and bad news using the sign of the Value Line forecast error and the sign of the price change. Under the Value Line method, good (bad) news events are those in which the actual 172 Contemporary Accounting Research reported earning is greater (less) than the most recent Value Line forecast. When the Value Line forecast is missing or when the reported earnings is equal to the Value Line forecast, the event is classified as neutral news. Under the price change method, good (bad) news events are those in which the price change from the midpoint of the quote at the time of the announce- 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 joint frequency distribution of earnings announcements 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 announcements (over 40 percent). 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 Long Short Percent Long Short Percent Difference relative to DJNS positions positions long positions positions long {i stat) announcement -50 to-41 892 675 56.9 111 693 52.9 +2.23 -40 to -31 1026 717 58.9 947 768 55.2 +2.16 -30 to-21 1095 904 54.8 1069 921 53.7 +0.67 -20 to-11 1285 986 56.6 1136 1096 50.9 +3.83 -lOto-1 1517 1272 54.4 1414 1460 49.2 +3.88 Total pre- 5815 4554 56.1 5343 4938 52.0 +5.92 announcement + 1 to +10 1453 1461 49.9 1548 1375 53.0 -2.36 + 11 to+20 1459 1092 57.2 1313 1095 54.5 + 1.89 +21 to +30 1290 1024 55.7 1184 942 55.7 +0.03 +31 to+40 1124 980 53.4 1117 805 58.1 -2.99 +41 to +50 1051 937 52.9 952 817 53.8 -0.52 Total post- 6377 5494 53.7 6114 5034 54.8 -1.69 announcement Option Trading, Price Discovery, and Eamings News Dissemination 173 TABLE 4 cont'd. Panel B: Results in clock time (two-hour trading intervals) Good news earnings Bad news earnings Clock time Long Short Percent Long Short Percent Difference relative to positions positions long positions positions long {z stat) announcement < - 8 hours 188 228 45.2 283 224 55.8 -3.18 - 8 to - 6 hours 372 330 53.0 294 288 50.5 +0.84 - 6 to - 4 hours 619 576 5L8 682 617 52.5 -0.32 - 4 to - 2 hours 1107 782 58.6 938 896 51.1 +4.55 - 2 hrs to -1 min. 3529 2638 57.2 3146 2913 51.9 +5.89 Total pre- 5815 4554 56.1 5343 4938 52.0 5.92 announcement 0 min. to +2 hours 3798 2917 56.6 3634 2744 56.9 -0.46 +2 to +4 hours 1054 969 52.1 951 914 51.0 +0.67 +4 to +6 hours 556 572 49.3 599 544 52.4 -1.43 +6 to +8 hours 459 481 48.8 472 348 57.6 -3.64 > +8 hours 510 555 47.9 458 484 48.6 -0.27 Total post- 6377 5494 53.7 6114 5034 54.8 -1.69 announcement * This table reports the frequency and proportion of long and short positions 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 equity market return from the announcement time to the end of Day +2 is positive (negative). The times of the announce- ments are obtained from the Dow Jones News Service (DJNS). All transactions classifiable as buys or sells are included provided they are executed within two trading days of the announcement time. Panel A reports results in transaction time (for ±50 trades immediately around the release time), and Panel B reports results in clock time (in 2-hour trading inter- vals). The z statistics are based on a chi-squared test of the null hypothesis that the long and short positions taken are uncorrelated with sign returns associated with the announcement. 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. Before good news announcements. Panel A shows that 56.1 percent of the option trades represent long positions in the underlying stock. However, before bad news announcements, only 52.0 percent of the option trades represent long positions. The z statistic for this difference is 5.92. Using the postannounce- ment proportions as benchmarks. Table 4 shows an increase in long positions before good news as well as an increase in short positions before bad news. Panel B shows that although the shift is most pronounced in the four hours 174 Contemporary Accounting Research immediately prior to the DJNS news release, we find once again evidence that the direction of option trades anticipate the subsequent price move. Although Table 4 results suggest that active-side option trades anticipate the nature of earnings news, these results may be limited by two design issues. First, the chi-squared statistics may be biased upwards if option trades are pos- itively and serially correlated, that is, long (short) positions tend to follow long (short) positions. Second, active-side trades may anticipate future price moves even when no earnings news is announced, tf option prices are sensitive to order imbalances, then the Table 4 results may not be related to earnings infor- mation. We address these issues in the next section through the use of a pseu- do-announcement methodology. Trading profits tn addition to examining the direction of option trades, we also examine their profitability. The main purpose of these tests is to evaluate the extent to which option traders participate in price discovery, tf option traders bring private information to market, then the direction of active-side option trades will antic- ipate subsequent price movements. This movement will yield short-run profits to active-side option trades, that is, when option traders initiate buys (sells), prices are more likely to move up (down). 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 compute 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 price at the end of Day +2 for that particular 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- gy mimics the trading profit of an option trader who closes his or her position at the end of Day +2 at the quoted price. In effect, it represents the trading prof- it after costs due to bid-ask spreads. We refer to this return as the "realizable retum" (ReRet). However, because trades often occur inside the quoted spread, our measure understates the actual trading profit from this strategy. In the third strategy, we assume the long or short position by trading in the underlying stock. Each option trade is accompanied by the corresponding stock price based on the last trade in the equity market. We assume a long (short) Option Trading, Price Discovery, and Earnings News 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 compute the "equity return" (EqRet). This trading rule mimics the returns an option trader would receive in the equi- ty market. Because the last equity trade could be either a buy or a sell, the equi- ty return does not include the cost of the bid-ask spread. Thus, EqRet is com- parable to MsRet 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] where X 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) Midspread Realizable Equity returns returns returns Timing of trade relative No. of to DJNS observations MsRet rstat ReRet tstat EqRet f stat event time (%) (%) (%) -50 to -41 3244 2.82 3.14 -9.41 -10.5 0.158 2.55 -40 to-31 3697 5.88 6.01 -7.68 -8.2 0.216 3.79 -30 to-21 4266 4.39 4.64 -10.08 -11.2 0.132 1.95 -20 to-11 4775 5.22 5.77 -9.66 -n.2 0.154 3.14 -lOto-1 6008 3.84 5.51 -11.33 -16.3 0.134 3.01 +1 to +10 6291 3.00 4.11 -13.56 -19.5 0.101 2.66 +11 to+20 5304 3.78 5.17 -11.55 -16.4 0.222 5.02 +21 to +30 4758 2.42 3.06 -12.40 -16.7 0.092 2.12 +31 to+40 4324 0.18 0.22 -14.24 -16.5 -0.135 -2.30 +41 to +50 4010 2.47 3.03 -11.25 -14.3 0.076 1.15 176 Contemporary Accoutiting Research TABLE 5 cont'd. Panel B: Results in clock time (2-hour trading intervals) Midspread Realizable Equity returns returns returns Clock time relative to No. of announ- observations MsRet tstat ReRet tstat EqRet f stat cement (%) (%) (%) < - 8 hours 979 1.70 1.02 -18.01 -11.31 0.087 0.88 - 8 to - 6 hours 1364 2.51 1.76 -14.62 -11.08 0.122 1.40 - 6 to - 4 hours 2677 4.11 4.00 -11.84 -12.01 0.195 3.13 - 4 to - 2 hours 4015 5.28 6.03 -10.39 -11.73 0.250 3.70 - 2 hrs to - 1 min. 12955 4.50 8.53 -8.33 -16.45 0.129 4.11 0 min. to +2 hours 13936 2.60 5.14 -11.15 -22.66 0.141 5.01 +2 to +4 hours 4198 2.68 3.43 -13.62 -17.97 0.035 0.83 +4 to +6 hours 2408 4.02 3.80 -12.76 -12.68 0.109 1.14 +6 to +8 hours 1965 0.77 0.76 -16.52 -16.68 -0.085 -1.64 > +8 hours 2181 1.86 1.90 -15.72 -18.07 -0.118 -1.20 * This table reports the average returns obtained from taking the active side of option trades immediately before and after the release of earnings news. Results using three different trad- ing rules are reported. MsRet is the average midspread return per trade, assuming trades are made at the middle of the bid-ask spread. For option buys (or sells), a long (or short) contract position is established at the middle of the prevailing spread at the time of the actual trade and unwound at the closing midspread price on Day +2. The average realizable return (ReRet) incorporates the bid-ask spread, so that buys (sells) are established at the actual trade price and unwound at the closing bid (ask) price on Day +2. The average equity return (EqRet) is computed using the stock price in the equity market at the time of the option trade. For each option trade, a corresponding long (or short) position is taken in the equity market using the last equity trade price and unwound at the last equity trade price on Day +2. All returns are expressed in percent. The times of the announcements are obtained from the Dow Jones News Service (DJNS). All transactions classifiable as buys or sells are included, provided they are executed within two trading days of the announcement time. Panel A reports results in trans- action time (±50 trades), and Panel B reports results in clock time (2-hour trading intervals). The t statistics are based on a test of the null hypothesis that the average return is not signif- icantly different from zero. Table 5 reports the results of the three trading-rule tests for the 50 option trades immediately before and after the earnings announcement. Panel A reports the results in transaction time, and panel B groups the trades in clock time. In both panels, the MsRet results are consistently positive and significant, indicating that option traders are informed about short-term future price changes. Specifically, the magnitude of MsRet suggests that, ignoring transac- tion costs, option traders gain around three to six percent on their contracts in Option Trading, Price Discovery, and Eamings News Dissemination 177 the days around the earnings release. In contrast, the ReRet results show that although initiators of option trades may anticipate the price move, high bid-ask spreads in the option market make such trades unprofitable. Tbe ReRet result suggests tbat active-side option traders do not make abnormal profits. However, it does not imply that traders are irrational for choosing to trade options. To assess whether these traders behave rationally (i.e., optimally), we need more information about costs and benefits for com- parable trades in the stock market. Moreover, we note that approximately one- third of the option trades have positive ReRets. For these traders, the option strategy proved profitable even after bid-ask spreads. The EqRet results show that, ignoring bid-ask spreads, trades executed in the equity market also yield positive returns. The t statistics on EqRets are lower than for MsRet, but still statistically significant. This result shows tbat the information brought to market by active-side traders was not yet impound- ed in tbe stock price at the time of the option trade. Table 5 sbows that EqRets are mucb smaller than MsRets. The average EqRet for preannouncement option trades is only around 16 basis points, compared to 400 to 500 basis points for MsRet. This difference reflects the greater leverage available in the option mar- ket, as well as the greater risk borne by option traders. As mentioned previously, MsRet results may not be attributable solely to the release of earnings news. Prior studies (e.g., Hasbrouck 1988; Lee and Ready 1991; and Petersen and Umlauf 1991) have shown that the active-side of each trade foreshadows subsequent price moves, that is, buyer (seller) initi- ated trades tend to be followed by increases (decreases) in stock prices. This pattern reflects the adverse selection problem faced by market makers. Because market makers are relatively uninformed, they infer the arrival of information from incoming active-side orders. Specifically, tbey respond to buyer-initiated trades by moving the price up and to seller-initiated trades by moving the price down. If option traders bring private information to market, a positive MsRet results even when no earnings news is released. To compare the profitability of active-side trades in event and nonevent periods, we generate a sample of "pseudo-announcements." For each announcement in our sample, we create a pseudo-announcement by retaining the same time of day and randomly drawing a date distribution of nonan- nouncement dates for the same firm. For each pseudo-announcement, we also draw the nearest 50 trades immediately before and after the announcement time (provided these trades take place after the opening of trading on Day - 2 and before the close of trading on Day +2). We then replicate the three trading prof- it tests using this random sample of pseudo-announcements. Table 6 reports tbe results for our pseudo-announcements. This table shows that MsRet is positive for all 10 trade groups, significantly so in six groups. Consistent with prior findings in equity trading, the direction of active-side option trades also forecasts future price changes. However, the information advantage of the active option trades is higher immediately before the earnings 178 Contemporary Accounting Research news release. Table 6 shows that the average MsRet during nonannouncement periods is approximately two percent. In comparison, the midspread-to-mid- spread return on option trades during announcement periods (MsRet in 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* Midspread Realizable Equity returns returns returns Timing of trade relative No. of to DJNS observations MsRet f stat ReRet tstat EqRet <stat event time (%) (%) (%) -50 to ^ 1 2970 0.591 0.76 -n.49 -15.1 -0.118 -1.65 -40 t o - 3 1 3312 1.665 2.11 -11.14 -14.8 0.039 0.77 -30 t o - 2 1 3892 0.346 0.47 -12.73 -17.7 -0.027 -0.53 -20 to -11 4833 2.416 2.73 -12.23 -15.5 -0.016 -0.41 -lOto-1 5973 2.998 4.36 -12.45 -18.8 -0.005 -0.14 +1 to+10 6163 0.236 0.44 -16.18 -29.8 -0.065 -1.84 +11 to+20 5084 0.193 0.35 -14.90 -26.8 -0.116 -3.48 +21 to+30 4381 2.447 4.03 -12.15 -20.6 0.029 0.82 +31 to +40 3888 1.928 2.99 -12.15 -19.2 0.260 1.17 +41 to +50 3457 L564 2.13 -11.87 -16.9 -0.406 -1.62 This table reports the average returns obtained from taking the active side of the 50 option trades immediately before and after pseudo-announcements. For each actual announcement, a pseudo-announcement is created using the same firm and time of day. but a randomly select- ed nonannouncement date. Results using three different trading rules are reported. MsRet is the average midspread return per trade, assuming trades are made at the middle of the bid-ask spread. For option buys (or sells), a long (or short) contract position is established at the mid- dle of the prevailing spread at the time of the actual trade and unwound at the closing mid- spread price on Day +2. The average realizable return {ReRet) incorporates the bid-ask spread, so that buys (sells) are established at the actual trade price and unwound at the clos- ing bid (ask) price on Day +2. The average equity return {EqRet) is computed using the stock price in the equity market at the time of the option trade. For each option trade, a corre- sponding long (or short) position is taken in the equity market using the last equity trade price and unwound at the last equity trade price on Day +2. The times of the actual announcements are obtained from the Dow Jones News Service (DJNS). All transactions classifiable as buys or sells are included, provided they are executed within two trading days of the pseudo- announcement time. The t statistics are based on a test of the null hypothesis that the average return is not significantly different from zero. Option Trading, Price Discovery, and Eamings News Dissemination 179 TABLE 7 Abnormal profitability of option trades around earnings releases after controlling for matched-sample pseudo-announcements* Midspread Realizable Equity returns returns returns Timing of trade relative No. of to DJNS observations MsRet tstat ReRet tstat EqRet <stat event time (%) (%) (%) -50 to -41 1589 1.76 1.11 1.79 1.14 0.220 1.57 -40 t o - 3 1 2626 2.73 1.86 2.47 1.76 0.198 2.11 -30 t o - 2 1 3442 2.74 1.94 2.13 1.59 0.112 1.47 -20 t o - 1 1 4156 2.45 1.85 2.06 1.71 0.112 1.65 -lOto-1 5484 1.51 1.56 1.85 1.96 0.121 1.95 + 1 to+10 5734 3.04 3.41 3.11 3.46 0.239 4.34 +11 to+20 4568 3.85 3.76 3.55 3.59 0.269 1.85 +21 to +30 4047 -0.43 -0.38 -0.73 -0.69 0.214 0.81 +31 to +40 3134 -1.30 -1.00 -1.54 -1.20 -0.11 -1.65 +41 to+50 2030 -0.29 -0.23 -0.46 -0.36 0.109 0.87 * This table reports the average abnormal returns obtained from taking the active side of the 50 option trades immediately around earnings releases. For each announcement, a pseudo- announcement is created using the same firm and time of day, but a random nonannounce- ment date. Each trade is matched with a corresponding trade from the pseudo-announcement. Abnormal return is defined as the actual return per trade, minus the return on the matching trade, averaged across all paired trades. Three different trading rules are used. MsRet is the average midspread return, assuming trades are made at the middle of the bid-ask spread. For option buys (or sells), a long (or short) contract position is established at the middle of the prevailing spread at the time of the trade and unwound at the closing midspread price on Day +2. The average realizable return (ReRet) incorporates the bid-ask spread, so that buys (sells) are established at the actual trade price and unwound at the closing bid (ask) price on Day +2. The average equity return (EqRet) is computed using the stock price in the equity market at the time of the option trade. For each option trade, a corresponding long (or short) position is taken in the equity market using the last equity trade price and unwound at the last equity trade price on Day +2. All transactions classifiable as buys or sells are included provided they are executed within two trading days of the announcement time. The / statistics are based on a test of the null hypothesis that the average return is not significantly different from zero. To evaluate the incremental trading profit accruing to active-side option trades around earnings news, we subtract the returns on pseudo-announcement trades from the returns on trades around actual earnings announcements. Table 7 reports the average abnormal trading profit of option trades after controlling for corresponding trades from pseudo-announcements. The midspread returns in this table show that even after controlling for the information advantage of active-side trading in nonannouncement periods, option traders make abnormal profits immediately around earnings news releases. For Trades -30 to -1-20, active option trades earn abnormal profits of two to four percent. 180 Contemporary Accounting Research Interestingly, the results for the realizable returns (ReRet) are also statisti- cally significant and similar in magnitude. Because the difference between these two columns is due solely to changes in the quoted spread during event periods, these results imply that quoted spreads increase only marginally dur- ing the announcement period. The equity return (EqRet) shows that the infor- mation advantage in option trades can also be detected using equity trade prices. During the preannouncement period, EqRet is marginally higher than normal. However, the strongest information effect comes from the 10 trades immediately after the announcement. These trades realize an average return of 0.24 percent (t statistic=4.34) over two days. Bid-ask spreads and absolute deltas As a final test, we compare the composition of contracts traded in announce- ment periods to those in matching pseudo-announcements. Specifically, we focus on changes in the bid-ask spreads and absolute deltas for contracts trad- ed during the announcement. As discussed previously, bid-ask spreads should increase if information asymmetry risk (the risk of trading with an informed trader) increases around earnings releases. The average absolute delta should also increase for announcement trades if informed traders prefer option con- tracts that provide greater leverage. Table 8 reports summary statistics on the effective spread and absolute deltas for all announcement trades and their matching pseudo-announcement trades. The two variables in this table are as follows; Sprd = effective spread = 2 I TradePrice - Midspreadl, and I A I = absolute delta - I 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 absolute delta for each contract (I A I) measures the sensitivity of the contract price (C) to changes in the stock price (5). The option valuation pro- cedures followed to compute each contract's delta and implied volatility are described in Appendix 2. Table 8 shows that, during nonannouncement periods, the average effective spread is .158 or 15.80 per transaction. During the announcement period, the average effective spread increases to 16.3(i per transaction. This increase is due primarily to the widening of spreads in the postannouncement period, to 16.60 per transaction. The five percent increase in postannouncement spreads is somewhat lower than the 18 percent increase in effective spread for equity mar- kets reported in Lee et al. (1993, Table 5). This increase in effective spreads is consistent with greater information asymmetry risk around earnings releases. However, in economic terms, the effect is not large. Option Trading, Price Discovery, and Earnings News Dissemination 181 TABLE 8 Effective hid-ask spreads and contract deltas during earnings announcements* Panel A: Effective bid-ask spreads (Sprd) Pseudo- announcement Announcement period trades trades Aggregate Preannouncement Postannouncement No. of trades 58041 60656 28564 32092 Mean 0.158 0.163 0.159 0.166 Median 0.130 0.130 0.130 0.130 t statistic 7.05 0.55 11.08 Panel B: Absolute contract deltas (Delta) Pseudo- announcement Announcement period trades trades Aggregate Preannouncement Postannouncement No. of observations 58041 60656 28564 32092 Mean 0.518 0.515 0.513 0.517 Median 0.485 0.476 0.469 0.483 t statistic -2.80 -4.34 -0.67 * This table reports the average effective spread (Sprd) and the average absolute contract delta (.Delta) for option contracts traded immediately around earnings announcements and match- ing pseudo-announcements. A pseudo-announcement has the same firm and time of day as an actual announcement, but is based on a randomly selected nonannouncement date. A trade is included in the table if it is among the 50 trades executed immediately before or after each announcement (or pseudo-announcement), provided it is also within two trading days of the DJNS announcement (or pseudo-announcement) time. Effective spread (Sprd) for each trade is defined as two 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 positive deltas and puts have negative deltas. Panel B reports the average absolute delta. The / statistics are based on a test of the null hypothesis that the mean Sprd or Delta for announcement trades is not significantly different from the mean for pseudo-announcements. Panel B of Table 8 shows that the average absolute delta of traded contracts is lower for announcement periods. The main difference is in the preannounce- ment period, when average deltas drop from .518 to .513. To put this change into economic perspective, the average "elasticity" of announcement period trades is 14.7, compared to 15.0 for pseudo-announcement trades.^^ In other words, a one percent change in stock price results in an average change of 14.7 percent in the price of contracts traded during earnings announcements. By comparison, a one percent change in stock price results in an average change 182 Contemporary Accounting Research of 15 percent in the price of contracts traded during nonannouncement periods. The small 0.3 percent decrease in elasticity suggests that option traders do not forego much leverage by choosing lower delta (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 deltas have wider effective spreads.^'' The results in Table 8 suggest that these costs outweigh the potential benefits of trading in higher leverage contracts. Conclusion 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 volume 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 the 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 delta 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 informed traders from using the more highly leveraged contracts. Collectively, our findings suggest a role for option trading in the dissemi- nation of earnings news. Prior studies with equity market data imply that the availability of option markets enhances the price efficiency of the stock market with respect to earnings news. We provide direct evidence that this enhance- ment is attributable to the private information option traders bring to market. In particular, our findings suggest some option traders have price-relevant infor- mation about upcoming earnings announcements. Option Trading, Pdce Discovery, and Eamings News Dissemination 183 Our findings also contribute to the literature on the intermarket linkage between stocks and options. Recent evidence on the speed of information trans- fer between option and equity markets has been mixed (e.g., Stephan and Whaley 1990 and Chan et al. 1993). These studies employ Granger-Sims causality tests, without conditioning on an exogenous information signal. In contrast, we isolate abnormal trading activities that relate to a known informa- tion signal and show faster and more informed trading in the option market. Our evidence suggests that option market trades lead the equity market, at least during periods of earnings news dissemination. These findings imply an economic role for the option market as a cost-effi- cient mechanism for price discovery. As suggested by Grossman (1988), options are not merely redundant securities that can be substituted by dynamic trading strategies in stocks and bonds. Rather, our results on the speed and direction of option trades support the view that some informed traders are led first to the option market. In this sense, the option market offers a low-cost means for impounding new information into prices. Appendix 1 List of 141 sample firms 02224910 AA ALUMINUM CO AMERICA 01447610 AAL ALEXANDER ALEXANDER SER 02635110 AGC AMER GEN CORP 28176010 AGE A.G.EDWARDS INC 02687410 AIG AMERIINTL GROUP INC 02680410 AIT AMERIINEORMATION TECH CO 02390510 AMH AMDAHL CORP 03189710 AMP AMP INC 03190510 AN AMOCO CORP 03251110 APC ANADARKO PETROLEUM CORP 04882510 ARC ATLANTIC RICHFIELD CO 05430310 AVP AVON PRODUCTS INC 02581610 AXP AMERICAN EXPRESS COMPANY 09702310 BA BOEING CO 06605010 BAC BANKAMERICA CORPORATION 07181310 BAX BAXTER INTERNATIONAL INC 11704310 BC BRUNSWICK CORP 09738310 BCC BOISE CASCADE CORP 09179710 BDK BLACK DECKER CORP 07785310 BEL BELL ATLANTIC 05873210 BLY BALLY MFG CORP 07159310 BMG BATTLE MOUNTAIN GOLD CO CLA 11009710 BMY BRISTOL MYERS CO 184 Contemporary Accounting Research 12189710 BNI BURLINGTON NORTHERN INC 08750910 BS BETHLEHEM STEEL CORP 07390210 BSC BEAR STEARNS COMPANIES INC 17119610 C CHRYSLER CORP 20491210 CA COMPUTER ASSOC INTL INC 12484510 CBS CBS INC 13985910 CCB CAPITAL CITIES /ABC INC 19121910 CCE COCA-COLA ENTERPRISES INC 17303410 CCI CITICORP 17052010 CCN CHRIS-CRAFT INDUSTRIES INC 21236310 CDA CONTROL DATA CORP 19044110 CGP COASTAL CORP 15852510 CHA CHAMPION INTERNATIONAL CORP 12550910 CI CIGNA CORP 19416210 CL COLGATE-PALMOLIVE CO 20536310 CSC COMPUTER SCIENCES CORP 24736110 DAL DELTA AIR LINES INC DEL 25365110 DBD DIEBOLD INC 26353410 DD DU PONT DE NEMOURS E I CO 25384910 DEC DIGITAL EQUIPMENT CORP 25468710 DIS DISNEY WALT COMPANY 26054310 DOW DOW CHEMICAL CO 26188510 DRY DREYFUS CORP 29284510 EC ENGELHARD CORP 27746110 EK EASTMAN KODAK CO 27805810 ETN EATON CORP 34537010 F FORD MOTOR CO 31330910 FDX FEDERAL EXPRESS CORP 31818110 FFC FIREMANS FUND CORP 34386110 FLR FLUOR CORP 31945510 ENB FIRST CHICAGO CORP 34583810 FRX FOREST LABS INC 35671410 FTX FREEPORT MCMORAN INC 36935210 GCN GENERAL CINEMA CORP 36955010 GD GENERAL DYNAMICS CORP 36960410 GE GENERAL ELECTRIC CO 21932710 GLW CORNING GLASS WORKS 37044210 GM GENERAL MOTORS CORP 39109010 GNN GREAT NORTH NEKOOSA CORP 36476010 GPS THE GAP INC Option Trading, Price Discovery, and Earnings News Dissemination 185 40018110 GQ GRUMMAN CORP 39144210 GWF GREAT WESTERN FINANCIAL CO 36868210 GY GENCORP INC 40621610 HAL HALLIBURTON CO 43739D10 HFD HOMEFED CORP 43507110 HIA HOLIDAY CORP 43761410 HM HOMESTAKE MINING CO 42307410 HNZ HEINZ H.J CO 43850610 HON HONEYWELL INC 41387510 HRS HARRIS CORP 44485910 HUM HUMANA INC 42823610 HWP HEWLETT-PACKARD CO 32054810 I FIRST INTERSTATE BANCORP 45920010 IBM INTL BUSINESS MACHINES CORP 45950610 IFF INTL FLAVORS FRAGRANCES 45988410 IGL INTL MINERALS CHEM CORP 46014610 IP INTERNATIONAL PAPER CO 45067910 ITT ITT CORP 47816010 JNJ JOHNSON AND JOHNSON 48258410 KM K MART CORP 49238610 KMG KERR-MCGEE CORP 19121610 KO COCA-COLA CO 50545810 LAC LAC MINERALS LTD 53802110 LIT LITTON INDUSTRIES INC 54385910 LOR LORAL CORP 53271610 LTD THE LIMITED INC 54042410 LTR LOEWS CORP 84474110 LUV SOUTHWEST AIRLINES CO 57777810 MA MAY DEPARTMENT STORES CO 58013510 MCD MCDONALDS CORP 58505510 MDT MEDTRONIC INC 58283410 MEA MEAD CORP 59018810 MER MERRILL LYNCH CO INC 60405910 MMM MINNESOTA MNG MFG CO 60705910 MOB MOBIL CORPORATION 58933110 MRK MERCK CO INC 61166210 MTC MONSANTO CO 62886210 NCR NCR CORP 66680710 NOC NORTHROP CORP 65584410 NSC NORFOLK SOUTHERN CORP 186 Contemporary Accounting Research 63764010 NSM NATIONAL SEMICONDUCTOR CORP 66581510 NT NORTHERN TELECOM LTD 67634610 OG OGDEN CORP 67459910 OXY OCCIDENTAL PETROLEUM CORP 71344810 PEP PEPSICO INC 69642930 PLL PALL CORP 73109510 PRD POLAROID CORP 69562910 PWJ PAINE WEBBER GROUP INC 70990310 PZL PENNZOIL CO 75127710 RAL RALSTON PURINA CO 77434710 ROK ROCKWELL INTL CORP 1 PAR 75511110 RTN RAYTHEON CO 81238710 S SEARS ROEBUCK CO 82270360 SC SHELL TRANS TDG PUB LTD DS 82434810 SHW SHERWIN-WILLIAMS CO 83083010 SKY SKYLINE CORP 80685710 SLB SCHLUMBERGER LTD 87161610 SYN SYNTEX CORPORATION 03017710 T AMERICAN TEL TEL CO 87538210 TAN TANDY CORP 87933510 TDY TELEDYNE INC 87913110 TEK TEKTRONIX INC 89233510 TOY TOYS R US INC 89604710 TRB TRIBUNE COMPANY 88250810 TXN TEXAS INSTRUMENTS 90553010 UCC UNION CAMP CORPORATION 90921410 UIS UNISYS CORP 91530210 UPJ UPJOHN COMPANY 90291110 UST UST INC 91301710 UTX UNITED TECHNOLOGIES CORP 93443610 WCI WARNER COMMUNICATIONS INC 97463710 WGO WINNEBAGO INDS INC 96332010 WHR WHIRLPOOL CORPORATION 96945710 WMB WILLIAMS COMPANIES 93114210 WMT WAL-MART STORES INC 96216610 WY WEYERHAEUSER COMPANY 30229010 XON EXXON CORP 98412110 XRX XEROX CORPORATION Option Trading, Price Discovery, and Eamings News Dissemination 187 Appendix 2 Option vatuation assumptions and procedures To compute an option's sensitivity to the underlying stock price (dC/dS, or delta), we use an option valuation procedure based on a binomial approxima- tion to the Black-Scholes model modified for dividends and early exercise. The implied volatility from this model is computed using a procedure similar to that in Harvey and Whaley (1992). The implied volatility is then used as input in the model to numerically compute each contract's delta. Dividend data (adjust- ed for stock distributions) is obtained from the CRSP database. Interest rates are computed daily from the average of Treasury Bill bid and ask quotes sup- plied by DRI. On each date, the entire term structure of forward interest rates is computed by linearly interpolating between available Treasury Bill maturities. Option valuation On each trading day, we decompose the stock price into the present value of the dividends during the remaining life of the option and the remaining capital- gains portion of the stock, that is: where 5« is the stock price on date n, Gn is the capital-gains portion of the stock price at date n, PV[Di ] is the present value of the dollar dividend paid on the stock on date t, and T is the option maturity date. Df is nonzero only for exdividend days. We assume that Gn follows a log-normal diffusion with a constant volatil- ity per unit time. Using the Black-Scholes risk-neutral argument, the rate of return on G« (and on the stock price) equals the riskless interest rate. The den- sity of the diffusion process governing G« is approximated by a discrete bino- mial model with the number of periods equal to the smallest integer multiple of the number of days to maturity, such that, the number of periods is at least 200. The stock price at each node in the binomial tree is set equal to the value of G/j at that node plus the present value of the dividends during the remaining life of the option. Option values are computed by backward induction, checking for early exercise at each node. For example, if Cn is the value of an American call option in time period n with strike price K, its value is given by the following recursive relationship: Cn =Max[(S^-K), E J where £„ is the conditional expectation on date n with respect to the risk-neu- tral probabilities, rn^n+1 is the forward interest rate from date n to date n+1, and h is the size of the time step in the binomial model. Given the call value at the 188 Contemporary Accounting Research maturity date as a function of the stock price, this equation can be solved recur- sively to compute the call value at date 0. A put option can be valued similarly. Implied volatility For each trading day, an implied volatility measure is computed separately for each option series (a series consists of all calls or puts with the same exercise price and maturity date). On the date of the actual earnings announcement, the implied volatility is computed separately for the intraday period before the earnings announcement and for the period after the announcement. Thus, any changes in the volatility induced by the announcement is reflected in the postannouncement pricing. The implied volatility of a contract is computed by minimizing the following function: . where j is the number of option trades in the sample, Cj is the market price of caliy, Sj is the contemporaneous stock price, and Cj(Sj,a) is the model price of call j as a function of the stock price Sj and volatility s. Note that because the trades may have occurred at different times during the day, the stock price for each trade may be different . Given the implied volatility for each option, we then numerically compute each option's delta using the binomial model. Endnotes 1 For example, see Skinner (1990), Ho (1993), Jennings and Starks (1986), Botosan and Skinner (1993). Also related are general studies of the effect of derivative products on stock price behavior (e.g., Figlewski and Webb 1993; Damodaran and Subrahmanyam 1992; and Skinner 1989); and studies of the intermarket linkage between options and equities (e.g., Stephan and Whaley 1990; Chan et al. 1993). 2 Using prior release dates, Kross and Schroeder (1984) show that over 80 percent of earnings announcements are within three days of the date predicted. Our discussions with market participants and specialists suggest traders often have even more precise information about the timing of releases. 3 We define long and short positions relative to the underlying security. For example, the purchase of a call and the sale of a put are both deemed long positions. We use a technique similar to Lee and Ready (1991) and Harris (1989) to identify the active-side of each trade—that is, whether it is buyer or seller initiated. 4 Note that the evidence shows some private information is incorporated first in the option market. Our result is tangential to, and does not directly address, the issue of whether option markets, on average, lead equity markets (i.e., the focus in earlier studies by Battacharya 1987; Anthony 1988b; Stephan and Whaley 1990; Chan et al. 1993). 5 Hasbrouek (1988), Lee and Ready (1991), and Petersen and Umlauf (1991) document this empirical phenomenon for equity markets. See Glosten and Milgrom (1985) and Easley and O'Hara (1987) for examples of formal models in which this effect arises. Option Trading, Price Discovery, and Eamings News Dissemination 189 6 The short-term option market returns we report are not to be confused with realizable risk-adjusted returns such as in Whaley and Cheung (1982). The purpose of our tests is to detect directional shifts in the incoming flow of market orders. They are not designed to provide an estimate of economic risk-corrected returns. 7 The delta of an option (defined as d C/<?S, whereC is the contract price andS is the stock price) measures the sensitivity of the contract price to changes in the price of the underlying stock. Calls have positiv&deltas, whereas puts have negative deltas. 8 The typical information asymmetry model (e.g., Copeland and Galai 1983 and Glosten and Milgrom 1985) assumes two types of traders: "informed" traders and "liquidity" traders. Informed traders trade because they have private information not currently reflected in prices, whereas liquidity traders trade for reasons other than superior information. Market makers sustain losses from trading with informed traders, and they recover these losses through the bid/ask spread. These models predict that greater information asymmetry between informed and liquidity traders will lead to wider spreads. In these models, information asymmetry risk can increase with an increase in either the proportion of informed traders or the precision of their information. 9 We define transaction costs broadly to include interest lost on margin accounts or short-sell proceeds, etc. 10 In a related study, Vijh (1990) observes that noise traders who mistakenly believe they have price-relevant information might also prefer the option market. 11 An option trader may initiate one of four transactions: open a purchase contract, open a sale contract, close a purchase contract, and close a sale contract. In the first two instances, the trader buys an option he does not already hold as a writer, thus increasing open interest. In the latter two instances, he cancels his position as a writer of some options, thereby reducing open interest. Consequently, increased trading in options could either increase or lower open interest, depending on whether contracts are being opened or closed. 12 Note that evidence of an earlier volume reaction in the option market does not imply option markets generally lead equity markets. As discussed in the following, option markets may be used to hedge expected increases in volatility associated with earnings news releases. This anticipative "volatility play" may result in an earlier volume reaction in the option market. 13 Note that even investors who hold hedged positions in options and the underlying stock are subject to increased risk during earnings announcements. This risk arises from the nonlinear relation between the stock price and the option price that, during a large price move, will expose the holder to risk. 14 In some low-volume contracts, the market maker is a designated specialist. However, even in these markets, the quotes are firm and tradable for at least 100 contracts. 15 These comparisons may be somewhat misleading, as option returns are more sensitive to the same news event than stock returns. Dividing each contract's effective spread by its absolute delta and stock price, we find relative spreads for options average around 0.8 percent of the stock price. This percentage is still larger than the average effective spread in equity markets (approximately 0.6 percent of stock price for our sample firms). 16 Relative spreads may differ across the two markets due to factors other than information asymmetry risk. The market microstructure literature identifies three components to the bid-ask spread, of which information asymmetry risk is only one [see Stoll (1989) for a good summary]. The other two factors are inventory 190 Contemporary Accounting Research costs and order processing or administrative costs. However, most market makers in options close the day "even," bearing little inventory risk. Moreover, the capital requirements and initiation fees for market making in options are generally much lower than those needed to become a specialist in equity trading. Therefore, these two factors are unlikely explanations for wider options spreads. 17 Using intraday data. Lee et al. (1993) show that, in equity markets, spreads widen and depths drop immediately before earnings news. Using daily closing quotes, Anthony (1987) finds no evidence of this phenomenon in the option market. As pointed out by Lee et al. (1993) in an equity context, the failure to detect this effect may be due to the coarseness of daily data. Later, we examine the effect of earnings announcements on the size of the bid-ask spread in the option market. 18 Besides trade and quote information on calls and puts, the CBOE data also report trading in straddles and spreads. A spread is a simultaneous long and short position in two or more contracts that differ in either their strike price (a money spread) or expiration date (a time spread). A straddle is a simultaneous long or short position in a put and a call with the same expiration date and strike price. Because the trading in spreads and straddles is minimal, these trades are excluded. 19 The four sample firms with some option activity on the AMEX are as follows: DEC, Disney, Dupont, and Tandy. 20 The results using number of contracts traded are qualitatively the same. 21 We do not distinguish between different option contracts at this point. However, in later tests, we do report on differences in the elasticity and bid-ask spreads of contracts traded during announcement periods and pseudo-announcement periods. 22 In general, more contracts are bought than are sold because some purchased contracts expire, whereas others are exercised early. Vijh (1988) shows that a greater proportion of option trades are executed at the ask price than at the bid price. Because call volume is much higher than put volume, our results on long and short positions are consistent with his findings. 23 The elasticity of a contract is its ahsolute delta multiplied by its stock price and divided by its contract price. It measures the percentage change in each contract's price for a one percentage change in its stock price. 24 Dividing our sample trades into quintiles ranked by absolute delta, we find a positive and monotonic relation between spreads and leverage: average effective spread for the top quintile (contracts with the highest absolute delta) is 0.21, as compared to 0.11 for the bottom quintile (contracts with the lowest absolute delta). References Anthony, J. H. Joint Option Equity Analysis: An Investigation of Information Trading In the Call Options Market. Proceedings: AAA Western Regional Meetings. 1988a. . 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Earnings Announcements, Stock Price Adjustment, and the Existence of Option Markets. Journal of Finance (1986), 107-125. John, K., A. Koticha, and M. Subrahmanyam. The Micro-Structure of Options Markets: Informed Trading, Liquidity, Volatility and Efficiency. Working paper. New York University, 1991. Kim, O., and R. Verrecchia. Market Reaction to Anticipated Announcements. Journal of Financial Fconomics (1991), 273-309. Kross, W., and D. Schroeder. An Empirical Investigation of the Effect of Quarterly Earnings Announcement Timing on Stock Returns. Journal of Accounting Research (1994), 153-176. Lee, C. M. C. Earnings News and Small Traders: An Intraday Analysis. Journal of Accounting and Economics (1992), 265-302. , and M. J. Ready. Inferring Trade Direction from Intraday Data. Journal of Finance (1991), 733-746. , B. Mucklow, and M. J. Ready. Spreads, Depths and the Impact of Earnings Information: An Intraday Analysis. 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Open Interest in Stock Options Around Quarterly Earnings Announcements. Journal of Accounting Research (1988), 353-372. Seppi, D. J. Block Trading and Information Revelation around Quarterly Earnings Announcements. Review of Financial Studies (1992), 281-305. Seyhun, N. H. Effectiveness of Insider Trading Sanctions. Journal of Law and Economics (1992), 149-182. Sims, C. A. Money, Income, and Causality. American Economic Review (1972), 540-552. Skinner, D. J. Options Markets and Stock Return Volatility. Journal of Financial Economics (1989), 61-78. . Option Markets and the Information Content of Accounting Earnings Releases. Journal of Accounting and Economics (1990), 191-211. Stephan, J. A., and R. E. Whaley. Intraday Price Change and Trading Volume Relations in the Stock and Stock Option Markets. Journal of Finance (1990), 191-220. Stoll, H. R. Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests. Journal of Finance (1989), 115-134. Vijh, A. M. Potential Biases from Using Only Trade Prices of Related Securities on Different Exchanges: A Comment. Journal of Finance (1988), 1049-1055. . Liquidity of the CBOE Equity Options. Journal of Finance (1990), 1157-1179. Whaley, R., and J. Cheung. Anticipation of Quarterly Earnings Announcements: A Test of Option Market Efficiency. Journal of Accounting and Economics (1982), 57-83,
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