Disagreements, private information, and the demand for options before earnings announcements

Abstract

We test whether investor uncertainty, disagreements, and private information about future equity price and variance outcomes impact the demand for, and the pricing of, options before earnings announcements. We proxy for excess option demand using straddle returns and use the option-to-stock trading volume ratio as a proxy for disagreement and private information. We find lower straddle returns around earnings announcements for firms with greater past option-to-stock trading ratios. This relationship holds conditional to other factors suggested to predict straddle returns, and the association appears specific to the announcement period. The association is driven by the prior trading of at-the-money options which have the greatest sensitivity to future volatility outcomes and shifts in post-earnings announcements volatilities. Finally, we find evidence that a higher option-to-stock trading volume ratio predicts a larger implied volatility term structure drop after the release of earnings information. Our results suggest that uncertainties and disagreements that drive variance trading lead to excess demand for hedging or speculative purposes around earnings announcements, and generate trading profits to investors willing to sell variance protection around these disclosure events.

Keywords: Volatility, earnings announcements, options, trading volume, variance risk premiums; disagreements, information asymmetry, uncertainty, straddles, forecasting

JEL Classification: G13, M40