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Options trading volume and stock price response to earnings announcements

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Abstract

We examine the effect of options trading volume on the stock price response to earnings announcements over the period 1996–2007. Contrary to previous studies, we find no significant difference in the immediate stock price response to earnings information announcements in samples split between firms with listed options and firms without listed options. However, within the sample of firms with listed options stratified by options volume, we find that higher options trading volume reduces the immediate stock price response to earnings announcements. This conforms with evidence that stock prices of high options trading volume firms have anticipated and pre-empted some earnings information in the pre-announcement period. We also find that higher abnormal options trading volume around earnings announcements hastens the stock price adjustment to earnings news and reduces post-earnings announcement drift.

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  1. In a broader genre of research on options trading and stock price discovery, prior studies have also documented mixed results. Studies such as Manaster and Rendleman (1982), Jennings and Starks (1986), and Chern et al. (2006) support a speedier stock price discovery for optioned firms because options trading disseminates private information into the market. However, studies by Stephan and Whaley (1990), Vijh (1990), and Choy and Wei (2009) argue that options trading is unrelated to information trading.

  2. Ball and Brown (1968), Jones and Litzenberger (1970), Latane et al. (1970), Joy et al. (1977), Latane and Jones (1979), Bernard and Thomas (1989, 1990), and others observe a consistently perceptible delay in the stock price response to earnings information in the post-earnings-announcement period. The academic literature offers three possible explanations: (1) methodological shortcomings in the studies examining such abnormal returns; (2) an increase in risk for companies experiencing extreme earnings surprises, where the abnormal return represents fair compensation for higher expected risk; (3) investors under-react to value-relevant information from earnings announcements or they process the information with a significant delay. The predominant hypothesis is that post-earnings-announcement drift is a delayed response to earnings information where a gradual, rather than immediate price adjustment occurs. Daniel et al. (1998) and Barberis et al. (1998) offer behavioural explanations for why investors might under-react to new information.

  3. Consider the argument made by Roll et al. (Roll et al. 2009, p. 4): “It can be argued that, ceteris paribus, markets for claims in firms with higher options trading volume should be more informationally efficient and thus valued more highly. It is worth noting that the mere listing of an option does not necessarily imply a valuation benefit of the type discussed above… Any valuation benefit of options listing should depend on substantial trading activity.” Admati and Pfleiderer (1988) point out that if the options market has insufficient trading volume, informed traders would find no advantage to trading in options.

  4. We find that options trading volume is significantly higher for firms with a long history of options listings compared to firms with more recent options listings. This can come about because option traders prefer to trade options on stocks with a well-established history of options trading or because the option exchanges had identified and listed options for firms with the highest demand for options trading first.

  5. A recent study by Drake et al. (2012) shows that when investors demand for earnings information rises, as proxied by Google searches in the pre-earnings-announcement period, stock price and stock trading volume changes reflect more of the upcoming earnings news and there are reduced stock price and stock trading volume responses when the earnings news is announced. Our study reports similar findings in the context of options trading.

  6. It is an old adage of Wall Street that “It takes volume to make prices move.” Findings in this study suggest that trading volume in both stock and options markets makes stock prices move.

  7. Ross (1976) suggests that the options market significantly improves market efficiency because it permits an expansion of contingencies covered by traded securities. Figlewski and Webb (1993) argue that options increase informational efficiency because put options and written call options effectively alleviate short-sale constraints. Since Ross’ study, the options market has grown exponentially in both number of assets with options listings and options trading volume.

  8. Earlier empirical research on the interaction between stock prices and the options market can be found in Chiras and Manaster (1978), Patell and Wolfson (1979), Manaster and Rendleman (1982), and Jennings and Starks (1986).

  9. Several early studies find that the information content of an earnings announcement is negatively associated with a firm’s information environment (Grant 1980; Atiase 1985; Collins et al. 1987; Freeman 1987; Dempsey 1989; Lobo and Mahmoud 1989; Shores 1990), where a firm’s information environment is proxied by firm size, by analyst following, or by the degree of financial press coverage. Skinner (1990) suggests a similar inverse relationship between the information content of an earnings announcement and the firm’s information environment in a setting where options trading is available versus options trading is not available.

  10. Several studies have examined options trading volume in relation to earnings announcements, such as Philbrick and Stephan (1993), Amin and Lee (1997), Ni et al. (2008), Choy and Wei (2009), and options trading volume in relation to take-over announcements, such as Cao et al. (2005). However, a focused examination of the linkage between options trading volume and the stock price response to earnings information appears to be so far non-existent.

  11. Cao and Wei (2008) find evidence that information asymmetry is greater for options than for the underlying stocks, implying that agents with private information would find the options market a more effective place for trading. Moreover, options trading volume is an essential condition for information trading using options, as Admati and Pfleiderer (1988) point out that informed traders are more active where volume is greater.

  12. Skinner (1990) employs a sample of 212 firms with options listed on the Chicago Board Options Exchange and American Stock Exchange over the period April 1973–December 1986. Ho (1993) uses a sample of 255 optioned firms over the period 1980–1983. Mendenhall and Fehrs (1999) examine 420 optioned firms over the period 1973–1993. Our sample is not only from a more recent period but also much larger than the samples in these studies.

  13. Roll et al. (2009) use dollar options trading volume in their study to evaluate the effect of options trading on firm valuation. Philbrick and Stephan (1993) compute three measures of options trading volume: options volume scaled by open interest, options volume scaled by number of outstanding shares, and options volume scaled by the number of shares traded. We repeated our tests using options volume measures in Roll et al. (2009) and Philbrick and Stephan (1993) and inferences in this study are robust to these choices.

  14. These data are recorded in the Security and Exchange Commission (SEC) Form 13f and are obtained from CDA Spectrum. Lev (1988) suggests that it is less costly for institutional investors to gather information and so they are better informed. Kim and Verrecchia (1994) show that institutional investors possess superior information and can process information better compared to individual investors.

  15. While it is convenient to determine options listings post 1996 in our study because Option Metrics starts coverage from 1996 onwards, we do not have options trading data for firms that were optioned before 1996. We hence choose to assign a value of 10 to the OPTYEAR variable in year 1996 for firms that were optioned before 1996. For these firms, we increment OPTYEAR by 1 every year they stayed optioned as identified in Option Metrics from 1997 onwards. Thus, for firms that were optioned before 1996 and stay optioned for the entire sample period, they have a maximum of 23 for OPTYEAR in 2009.

  16. Barclay and Warner (1993) employ WPC to study stock price changes associated with trade size and Barclay and Hendershott (2003) employ WPC to study stock price discovery in after-hours trading. WPC has been used widely in the literature to measure the stock price discovery in different trading periods relative to an overall trading window.

  17. We conduct two-sample t tests (not reported) for each return measure between the optioned firm sample and the non-optioned firm sample. Across all three return measures, we do not reject the null hypothesis that there is no statistically significant difference between the mean return from the optioned firm sample and the mean return from the non-optioned firm sample.

  18. An alternative is the Fama and MacBeth (1973) approach which entails estimating cross-sectional regressions separately in each calendar quarter and forming time series for all coefficients from the quarterly estimates. Inferences from results in this study are generally similar using Fama–MacBeth t-statistics.

  19. Skinner (1990) and Mendenhall and Fehrs (1999) use |CAR(-1, 0)| for their tests, while Ho (1993) uses ‘relative return variability’ (RRV) for her tests (see also Patell, 1976). We repeat the test in column 1 of Table 5 by replacing |BHAR[−1,+1]| with the natural log of RRV (or with |CAR(-1, 0)|) and inferences are not altered.

  20. The decile scores between 0 and 1 of explanatory variables in this model allow a convenient interpretation of the coefficient estimates. The intercept of 0.0353 is interpreted as the average stock return variability for the lowest decile of options trading volume firms (OPTVOL decile score equal 0). In the top decile of options trading volume firms (OPTVOL decile score equal 1), stock return variability is 0.0103 lower, indicating a reduction of nearly 30 percent in the stock return variability relative to that from the lowest decile of options trading volume firms.

  21. We also compute abnormal stock trading volume as an alternative measure of the information content of earnings announcements (see, for example, Drake et al. 2012). We repeat the analysis in Table 5, replacing absolute stock price response on the right hand side by abnormal stock trading volume in the three-day window surrounding earnings announcements and also document a significant negative relation between OPTVOL and earnings-announcement period abnormal stock trading volume.

  22. In Table 6, the coefficient on SUE*STOCKVOL is mostly insignificant. This means that the average liquidity in the equity market is not as important in determining the earnings response coefficient as the average liquidity in the options market. Kandel and Pearson (1995) suggest that liquidity trading can explain a large extent of on-going trading in non-announcement periods but also argue that the flow of information continuously arrives at the market during non-announcement periods in the form of informed trading. Our findings here indicate that on-going trading in the options market in non-announcement periods is more likely to be related to informed trading than liquidity trading.

  23. We also conduct our analysis of the effect of options trading volume on the earnings response coefficient which also includes non-optioned firms (not reported). Here, each non-optioned firm is assigned a value of 0 for its options trading volume (OPTVOL) variable. This analysis does not alter any finding in our study. Thus the difference in the stock price response to earnings information also extends to non-optioned and high options trading volume firms.

  24. We conduct the analysis in Table 6 with a number of alternative measures of options trading volume such as options trading volume that are orthogonal to firm characteristics (Naiker et al. 2013), options trading volume scaled by stock trading volume (Roll et al. 2010), options open interest, and options trading volume measured over the one-year period leading to day −11 prior to earnings announcements. We also document a negative relation between these alternative measures of options trading volume and the earnings response coefficient (not reported).

  25. An extensive literature beginning with Ball and Brown (1968) shows that stock prices in the pre-earnings-announcement period exhibit patterns that are consistent with information subsequently released by earnings announcements. Amin and Lee (1997) find that options traders initiate a greater proportion of long (short) positions immediately before good (bad) news.

  26. Bernard and Thomas (1989, 1990) and Bhushan (1994) suggest that uninformed investors underestimate the implications current earnings have for future earnings, and therefore under-react to earnings information, while informed investors react unbiasedly to earnings information. Thus, the trading activity of informed investors should move stock prices in the direction of the information contained in earnings news. Informed investors, however, will stop trading once stock prices are within threshold trading costs of the unbiased price.

  27. While the interactive coefficients on abnormal options trading volume are negative, the interactive coefficients on abnormal stock volume are significantly positive. Garfinkel and Sokobin (2006) and Lerman et al. (2008) also find that abnormal stock volume around earnings announcements leads to a higher magnitude of post-earnings-announcement drift. Thus, while abnormal stock volume and abnormal options volume are correlated, their impacts on post-earnings-announcement drift are different.

  28. A number of studies have documented significant market under-reaction to public information, such as post spin-off drift (Cusatis et al. 1993), post-stock-split drift (Desai and Jain 1997; Ikenberry et al. 1996), post-buy-back drift (Lakonishok and Vermaelen 1990; Ikenberry et al. 1995), post-dividend-initiation (omission) drift (Michaely et al. 1995), and profit and loss drift (Balakrishnan et al. 2010).

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  1. Department of Accounting and Finance, Monash University, Wellington Road, Clayton, Melbourne, VIC, 3800, Australia

    Cameron Truong

  2. Corrado Consultancy, Melbourne, Australia

    Charles Corrado

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Truong, C., Corrado, C. Options trading volume and stock price response to earnings announcements. Rev Account Stud 19, 161–209 (2014). https://doi.org/10.1007/s11142-013-9243-x

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