Volatility Spreads and Earnings Announcement Returns

Abstract

Prior research documents that volatility spreads predict stock returns. If the trading activity of informed investors is an important driver of volatility spreads, then the predictability of stock returns should be more pronounced during major information events. This paper investigates whether the predictability of equity returns by volatility spreads is stronger during earnings announcements. Volatility spreads are measured by the implied volatility differences between pairs of strike price and expiration date matched put and call options and capture price pressures in the option market. During a two-day earnings announcement window, the abnormal returns to the quintile that includes stocks with relatively expensive call options is more than 1.5 percent greater than the abnormal returns to the quintile that includes stocks with relatively expensive put options. This result is robust after measuring volatility spreads in alternative ways and controlling for …firm characteristics and lagged equity returns. The degree of announcement return predictability is stronger when volatility spreads are measured using more liquid options, the information environment is more asymmetric, and stock liquidity is low.

Keywords: cross-section of equity returns, volatility spreads, equity options, information flow, put-call parity.

JEL Classification: G10, G12, G13, G14