The effect of option transaction costs on informed trading in the options market around earnings announcements

• Author: Suresh Govindaraj,Chen Zhao,Yubin Li
• DOI: http://doi.org/10.1111/jbfa.12443
• Published date: 01 May 2020
• Date: 01 May 2020

DOI: 10.1111/jbfa.12443

The effect of option transaction costs on informed

trading in the options market around earnings

announcements

Suresh Govindaraj1YubinLi2Chen Zhao3

1Rutgers Business School-Newark and New

Brunswick, Rutgers, the State University of New

Jersey, Newark, NJ, United States

2School of Economics and Management, Harbin

Institute of Technology,Shenzhen, China

3School of Accounting, Southwestern University

of Finance and Economics, Chengdu, China

Correspondence

YubinLi, School of Economics and Management,

HarbinInstitute of Technology,Shenzhen, China.

Email:yubinresearch@gmail.com

Fundinginformation

Schoolof Accounting at the Southwestern Uni-

versityof Finance and Economics, Chengdu;

RutgersBusiness School - Newark and New

Brunswick,Rutgers University

Abstract

We investigate the effect of option markettransaction costs (a form

of market imperfection) on the ability of option implied volatility-

based measures to predict future stock returns and volatility around

quarterly earnings announcements. We find that the predictability

is significantly stronger for firms with lower option relative bid-ask

spreads. The effect is more pronounced around positive rather

than negative earnings news. We find no significant effect of option

transaction costs around randomly chosen dates when there is no

clustering of major information events. Trading strategies based

on option market predictors and transaction costs earn monthly

abnormal returns of 1.39% to 1.91%.

KEYWORDS

Earnings Announcements, Informed Trading, Option Transaction

Costs

JEL CLASSIFICATION

D23, G11, G13, G14, M41

1INTRODUCTION

In the last two decades, there has been an explosive growth in the volume of option contracts (specifically, stock

options), traded in the United States and elsewhere.1The options market, with relatively fewer restrictions on short

sales constraints, and higher leverage,has become an attractive alternative to the equities market for investors, espe-

cially those with superior information (Black, 1975). Recent empirical evidence supports the conjecture that infor-

mation is reflected in the options market before it is reflected in the stock market (e.g., Amin & Lee, 1997; An, Ang,

Bali, & Cakici, 2014; Bali & Hovakimian, 2009; Cao, Chen, & Griffin, 2005; Cremers & Weinbaum, 2010; Johnson &

So, 2012; Ni, Pan, & Poteshman, 2008; Pan & Poteshman, 2006; Roll, Schwartz, & Subrahmanyam,2010; Xing, Zhang,

& Zhao, 2010). For example, Cremers and Weinbaum (2010) document that implied volatility spread is positively

1The global options market volume was 13 billion contracts in 2018. The information is extracted from the website: https://fia.org/articles/fia-releases-

annual-trading-statistics-showing-record-etd-volume-2018. The US options market volume was about 5 billion contracts in 2018. This information was

extractedfrom the website: https://www.bloomberg.com/news/articles/2018-12-29/u-s-options-volume-at-record-in-2018-as-volatility-rocks-stocks.

J Bus Fin Acc. 2020;47:615–644. wileyonlinelibrary.com/journal/jbfa c

2020 John Wiley & Sons Ltd 615

616 GOVINDARAJ ETAL.

predictive of future stock returns. Ni et al. (2008) find strong evidence of volatility informed trading in the options

market.

We examine the impactof transaction costs of trading in the options market (hereafter referred to as option trans-

action costs) on the price discovery process of the options marketaround earnings announcements. Transaction costs

inject imperfections into the market, and are generally considered to be undesirable realities. More often than not,

they are simply ignored in many studies. In response to these costs, it is expected that rational informed traders will

weigh the benefits of their private information against the costs of trading in determining their course of action. We

expect these transaction costs to influence and have an impact on the price discoveryprocess of the options market,

especially around important corporate news events.Consequently, they cannot be ignored. Our paper explicitly incor-

porates these costs in the analysis and examinestheir impact on option trading and the price discovery process around

earnings announcements. In addition, we also investigate the relative impact of transaction costs across the nature of

news events (good and bad news).

An important component of option transactioncosts is the option relative bid-ask spread.2For example, for all firms

in the Center for Research on Security Prices (CRSP) database during the 1996 to 2011 period, the average relative

bid-ask spread of short-term at-the-money (ATM)call options is as high as 24.3% and the standard deviation is 31.7%.

By contrast, the average bid-ask spread of the underlying stocks in the CRSP database is only 2.4%, and the standard

deviationis 4.7%. Therefore, we examine the effects of option bid-ask spread (relative to the bid-ask spread in the stock

market) on informed investors’ trading decisions, and whether these effects vary with the nature of the information

environment.

We conduct our analysis around earnings announcements for the following reasons. First, an earnings announce-

ment is generally considered a significant event that attracts a higher proportion of informed tradersrelative to nor-

mal times (Kim & Verrecchia, 1994). Consequently,the price discovery process in the options market is more intense

around earnings announcements (Atilgan, 2014; Jin, Livnat, & Zhang, 2012), which provides a suitable setting to exam-

ine the trading activities of informed investors.Secondly, unlike other information events that are dispersed and unan-

ticipated (e.g., mergers and acquisitions and stock repurchases), earnings are released every quarter on a scheduled

date with a clustering pattern. This enables us to explore whether informed traders would treat option transaction

costs as a filter in selecting which firms’ options to trade during the earnings season.

Specifically,we examine the impact of option transaction costs on two types of informed trading: directional infor-

mation trading and volatility information trading. By directional and volatility information trading, we mean using

option market-relatedmeasures to predict future stock returns and future stock return volatility, respectively (Cairney

& Swisher,2004; Cao et al., 2005; Cremers & Weinbaum, 2010; Doran, Fodor, & Krieger,2010; Fodor, Stowe, & Stowe,

2017; Truong,2012; Truong & Corrado, 2014; Xing et al., 2010).

First, we examine the effect of transaction costs (orthe relative bid-ask spread of options) on directional informed

trading in the options market. The directional informed option trading measures we adopt are the implied volatility

spread (IV spread) and the implied volatility skew (IV skew) in the pre-release window [−7, −1], relative to the earn-

ings announcement day (e.g., Cremers & Weinbaum, 2010; Jin et al., 2012; Xing et al., 2010). We document that the

predictability of IV spread and IV skew for abnormal stock returns overthe earnings announcement window [0, +2] is

stronger among firms with relatively low option bid-ask spreads, suggesting that transaction costs act as a filter when

informed investors decide which firms’ options to tradeduring the earnings season.

Next, we investigate if the effect of option transaction costs on informed trading differs in the case of good and

bad earnings news.3When there is good news, informed investors could trade either in the stock market or in the

options market, depending on the transaction costs and leverage of each market.If transaction costs are too high in

one market, they can easily migrate to the other to take a long position, resulting in less informed trading.However,

2Therelative bid-ask spread is defined as the ask minus the bid price, and divided by the average of the bid and ask prices.

3Priorstudies, such as Lu and Ray (2016) and Truong,Corrado, and Chen (2012), have examined options market asymmetric reactions to good and bad earnings

news.