The Post Earnings Announcement Drift and Option Traders

43 Pages Posted: 14 Sep 2012 Last revised: 16 Jan 2013

See all articles by Suresh Govindaraj

Suresh Govindaraj

Rutgers University - Rutgers Business School - Newark and New Brunswick

Sangsang Liu

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

Joshua Livnat

New York University; Prudential Financial - Quantitative Management Associates

Date Written: December 24, 2012

Abstract

The Post-Earnings Announcement Drift (PEAD) anomaly refers to the tendency of stock prices to continue drifting in the same direction as earnings surprises well through the subsequent earnings announcements; ignoring the autocorrelations in extreme earnings surprises across adjacent quarters. Currently, the two major competing theories to explain PEAD are: the risk premium hypothesis (RPH), which argues that the anomaly exists only because risk has been measured improperly; and, the under-reaction (behavioral) hypothesis (URH), which assumes investors do not completely utilize the auto-correlations of earnings surprises. We test the former (RPH) by using a finer metric for risk than used in prior research, namely, the change in implied volatilities obtained from options prices immediately before and after the earnings announcements. Inconsistent with the predictions of RPH: (1) we do not find a positive correlation between the implied volatility changes and earnings surprises; and (2) we find that implied volatilities (risk) actually decrease most after the earnings announcements for firms with the most positive earnings surprises. Using volatility based option trading strategies (straddles), we examine if option traders have a similar URH bias to those of equity traders. We find that option straddles based on extreme earnings surprises in the prior quarter are not more profitable than straddles on mild earnings surprises, indicating that option traders already incorporate the prior earnings surprise in option prices.

Keywords: Post-Earnings Announcement Drift Anomaly, Risk Premium Hypothesis, Under-Reaction Hypothesis, Implied (Option) Volatility

JEL Classification: G12, G13, G14, M41

Suggested Citation

Govindaraj, Suresh and Liu, Sangsang and Livnat, Joshua, The Post Earnings Announcement Drift and Option Traders (December 24, 2012). Available at SSRN: https://ssrn.com/abstract=2146181 or http://dx.doi.org/10.2139/ssrn.2146181

Suresh Govindaraj (Contact Author)

Rutgers University - Rutgers Business School - Newark and New Brunswick ( email )

1 Washington Park
Room #934
Newark, NJ 07102
United States

Sangsang Liu

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

1 Washington Park
Newark, NJ 07102
United States

Joshua Livnat

New York University ( email )

44 West 4th Street, Suite 10-76
Stern School of Business
New York, NY 10012-1118
United States
212-998-0022 (Phone)
212-995-4004 (Fax)

Prudential Financial - Quantitative Management Associates ( email )

2 Gateway Center
6th Fl.
Newark, NJ 07102
United States

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