Option Trading, Price Discovery, and Earnings News Dissemination*

Authors


  • *

    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, Vanderbuilt 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.

Abstract

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 preannouncement trading foreshadows subsequent earnings news. Specifically, we find option traders initiate a greater proportion of long (short) positions immediately before “good” (“bad”) earnings news. Midquote returns to active-side option trades are positive during 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 delta contracts. Collectively, the evidence shows option traders participate generally in price discovery (the incorporation of private information in price), and more specifically in the dissemination of earnings news.

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