Option Trading Activity, News Releases, and Stock Return Predictability
Author Information:
David Weinbaum, Syracuse University
Andrew Fodor, Ohio University
Dmitriy Muravyev, Michigan State University
Martijn Cremers, University of Notre Dame
Year of Publication:
Management Science (2022)
Summary of Findings:
While the arrival of new information is an important reason why option volume predicts stock returns, this relation depends on whether the information is scheduled or unscheduled because only the former affects volatility and thus option prices.
Research Questions:
1. Which categories of option trading volume carry information about future stock prices around corporate news announcements?
2. How do trading costs and margin costs affect ex-post profitability around corporate news events?
What we know:
Many papers provide evidence that option markets contain information that can be used to predict future returns on the underlying stocks and, in particular, around corporate news events. However, the literature does not consider separately the predictive ability of option strategies that involve buying versus selling options. Doing so is important given the patterns of implied volatilities around corporate news events and their effects on option prices: volatility increases prior to scheduled news releases, such as earnings announcements, and then quickly declines thereafter.
Novel Findings:
We study the return predictability owing to long and short option strategies around news events. Furthermore, we examine how trading costs and margin costs affect ex post profitability around news events, using realistic estimates of transaction costs derived from intraday option data. We predict and find that purchases of options are informative on news days and ahead of unscheduled events but not before scheduled events, and sales of options predict returns only ahead of scheduled news releases.
Implications for Practice : Only certain types of option volume contain information about the future direction of the underlying stocks: not all types of option volume are equally informative.
Implications on Research:
The paper provides several insights. We know that option volume is a stronger predictor of stock returns around news days than on other days. Thus, the arrival of new information is an important channel that explains why option volume predicts stock returns. We show that this relation depends crucially on whether the timing of the incoming information is scheduled or unscheduled because this affects expected volatility and thus option prices. Specifically, our framework explains why open-sell (open-buy) option volume predicts stock returns before scheduled (unscheduled) news. More broadly, earnings announcements are commonly used to study return predictability around news (beyond stock and option markets), and we introduce a novel explanation for why earnings results may not generalize to all news.
Full Citations:
Weinbaum, David; Andrew Fodor; Dmitriy Muravyev; and Martijn Cremers; 2022; Option Trading Activity, News Releases, and Stock Return Predictability; Forthcoming, Management Science.
Abstract:
We examine which categories of option trading volume carry information about future stock prices around corporate news announcements. We predict and find that purchases of options are informative on news days and ahead of unscheduled events but not before scheduled events, and sales of options predict returns only ahead of scheduled news releases. Therefore, while the arrival of new information is an important reason why option volume predicts stock returns, this relation depends on whether the information is scheduled or unscheduled because only the former affects volatility and thus option prices. We also study how trading costs and margin costs affect ex post profitability around news.
Click here to access Full Paper