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04/11/2011

Trading on Corporate Earnings News


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Trading on Corporate Earnings NewsEARNINGS ANNOUNCEMENTS & OPTIONED VS NONOPTIONED COMPANIES

A study by Roll, Schwartz, and Subrahmanyam (2009) found that options trading around earnings announcements has been steadily increasing every year since 1996. Before we begin with specific trading strategies, it makes sense to get a sense of the general behavior of options around earnings announcement periods.

The idea that companies with listed options have a larger amount of information impounded into their stock prices makes intuitive sense. And this is precisely what a study by Amin and Lee (1997) found about optioned companies. They found that this better information impounding happened for optioned companies in both their earnings announcement periods and their non-earnings-announcement periods—basically, all the time. Another study by Jennings and Starks (1986) uncovered evidence that’s consistent with this. They found that the price adjustment to earnings news (in the immediate aftermath of an announcement) is faster for optioned companies than it is for nonoptioned companies. What this discussion means for you in a practical sense is that it is unlikely that you, as an individual investor with limited resources, will have a consistent informational advantage over the market as a whole or over more sophisticated institutional investors. This has some major implications for your options-based trading strategies, which we’ll discuss later. (Namely, you’ll be unable to consistently discover true mispricings.)

Several studies have considered this issue with respect to options prices. Specifically, Ho (1993) found that, for optioned companies, 50% of earnings-related information is reflected in a company’s stock price even before the earnings announcement is made. Part of this is certainly because earnings information probably is leaked early. However, even if there were no information leak, this suggests that sophisticated institutional investors are estimating earnings accurately before they are announced. Contrast that with companies that have no options listed or traded. Remember, nonoptioned companies tend to be small-cap companies that not as many people pay attention to. Ho found that for nonoptioned companies, only about 30% of the information is reflected in prices before the earnings announcement. This large difference (50% versus 30%) indicates that it is much harder to gain an information advantage for optioned companies. Indeed, several studies examine this issue. For instance, a study by Mendenhall and Fehrs (1999) and another by Kim and Lee (2006) suggest that, if you are an informed trader with valuable information that the public does not have... Well, where would you go to extract the biggest bang for your buck? That’s right: You’d go to the options markets.2 So these studies found that the market reaction to earnings information is bigger in optioned companies because it is full of informed traders who put on leveraged positions to best exploit their information. Many investment websites and blogs take the time to tell their readers about large options positions that have recently been opened for certain companies. The idea is that if an investor has the money to put on such a large options position, chances are that he or she knows something we don’t know.

BEHAVIOR OF OPTIONS PRICES BEFORE & DURING THE EARNINGS ANNOUNCEMENT

Let’s move on to talk about the period before earnings are announced—the preannouncement period. In the preannouncement period, we know that smart money puts on trades to exploit their superior information. Amin and Lee’s 1997 study confirms this. They found that more long call positions and short put positions were opened before positive earnings surprises. Similarly, they found that more long put and short call trades were put on before bad earnings surprises. Although we can’t know for sure whether these directional option positions were profitable (because of what we know about the opposite reactions we discussed in Chapter 6, “Market Reactions to Earnings Surprises (Are Full of Surprises),” it’s clear that the options positions seem to be anticipating the nature of the earnings news before the news is announced. This is consistent with Ho’s 1993 finding that a fairly large portion—up to 50%—of information can be impounded into prices in the period right before earnings are announced. Roll, Schwartz, and Subrahmanyam (2009) also found that this effect was even stronger for companies that had a relatively higher number of analysts who follow the company and for companies with higher levels of institutional ownership. As usual, it’s the presence of these big players that makes it relatively more difficult to put on profitable trades—at least directional trades that are either bullish or bearish.

For more than 30 years, when a study by Patell and Wolfson (1979) was published, we have also known that the implied volatility of options tends to increase in the earnings preannouncement period. This is because nerves are frayed in the frenzied anticipation of the news. On average, implied volatilities tend to be higher than realized/historical volatilities. But the difference is even more pronounced right before earnings announcements. A study by Donders, Kouwenberg, and Vorst (2000) found similar increases in the open interest and trading volume of options in the preannouncement period. And the higher the options trading volume in the preannouncement period, the stronger the price anticipation during this period. (A study by Corrado and Truong (2009) also confirms this.) In general, these studies suggest that much action occurs in the preannouncement period. This isn’t surprising. Earnings announcements are the most prominent, regularly recurring corporate event for publicly traded companies.

Last, how things happen in the preannouncement period can predict how things will play out during the actual earnings announcement. Another finding of the Roll, Schwartz, and Subrahmanyam (2009) study is that higher trading volume in the preannouncement period tends to equate to less trading volume for the market reaction to the announcement itself. This makes sense. The more the action has been impounded into option prices in the preannouncement period, the less action the actual announcement will have. After all, only so much news can get impounded. The authors also found that, if relative options trading volume is high when the announcement happens (such as during the announcement day), the change in option prices also tends to be higher. That is, higher volume is related to bigger price action (regardless of the preannouncement trading volume).

Excerpted from Trading on Corporate Earnings News: Profiting from Targeted, Short-Term Options Positions by John Shon and Ping Zhou (FT Press, March 2011).


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