Aurora Borealis
1 May 2015 CFA Institute Journal Review

Trading in the Options Market around Financial Analysts’ Consensus Revisions (Digest Summary)

  1. Marc L. Ross, CFA

Traded options demonstrate asymmetry in their ability to foretell analysts’ revised recommendations on the underlying stock.

What’s Inside?

The authors research traded options’ predictive ability with respect to revisions of financial analysts’ recommendations on underlying stock prices and how such features inform a trading strategy. Additionally, they discover a profitable costless trading strategy arbitraging differences between the option price and the equity security on which it is based.

How Is This Research Useful to Practitioners?

The authors’ analysis is the first to discover how options-implied stock prices, implied volatility, and options trading volumes lead to changes in underlying stock prices that arise from an announcement of analysts’ consensus revisions. The options markets are, in effect, harbingers of this information.

A large dataset spanning 10 years is the subject of investigation. The authors cleanse these data of outliers with respect to trading volume and liquidity, and they implement further controls to remove potential biases arising from analyst herding and piggybacking. The scrubbed data undergo examination for behavior at earnings revision time through measures that consider volatility between like–kind options and skewness between out-of-the-money puts and at-the-money calls. The authors also examine trading volume in options markets and stock markets.

Options market behavior seems to imply abnormal returns in the underlying shares in proximity to the earnings revision announcement date, both before and after. The conclusions are robust to tests that disaggregate behavior between normal information flow among markets and information flow resulting from the earnings revision.

Such predictive traits of an information-rich options market inform investors’ ability to implement a costless arbitrage that shorts firms with low abnormal options-implied returns and goes long firms with high abnormal options-implied returns.

Students and practitioners of risk and portfolio management, as well as equity market strategists, would glean important information from this study.

How Did the Authors Conduct This Research?

The authors review existing literature on options markets’ information content and use four metrics to monitor the activity in options markets around the time of an analyst revision. The four metrics are

  • abnormal implied return, or the difference between the price of the synthetic security and the underlying;
  • volatility spreads, or the average difference in implied volatility between calls and puts with identical strike prices and expiration dates;
  • volatility skewness, or the difference between implied volatilities of out-of-the-money puts and at-the-money calls; and
  • relative volume in options and stock markets, or how volume in the former affects volume in the latter.

The authors examine US equity and options data from October 2000 to September 2009. The data are from IBES (consensus upgrade and downgrade changes), OptionMetrics (options data to produce options prices at the midpoint of bid and ask prices), and CRSP (stock price and financial accounting data). Filters scrub the data by removing thinly traded options, those lacking corresponding puts and calls with the same maturity and exercise price, options pairs with less than 5-day or greater than 90-day maturities, and low liquidity options. Further controls remove recommendation duplicates and reiterations and adjust for analyst herding and piggybacking to eliminate potential biased test results.

Evidence from all four measures indicates predictive options trading consistent with the pending analyst consensus revisions, although upgrades and downgrades may not be of the same magnitude. Similar results are obtained to a lesser degree in markets that receive analysts’ limited attention. Here, earnings announcement drift tends to be more pronounced and price discovery is delayed because of the scarcity of analyst coverage.

Regression analysis attempts to parse information flows to control for potential determinants of abnormal stock returns on the announcement day by studying the degree to which the abnormality of such returns is attributable to routine information exchange between stock and options markets and information specific to the earnings revision. The authors conclude that the options market leads the stock market in the transmission of earnings revisions’ impact on stock prices. Options’ information content informs a profitable trading strategy that buys options on firms with high abnormal implied returns and sells short options on those with low abnormal implied returns.

Abstractor’s Viewpoint

Because options allow for informed trading and price discovery, they are ideal tools for investors to hedge and speculate. The authors demonstrate options’ predictive power, which appears to suit options well as a profitable costless trading strategy that is long firms with high abnormal options-implied returns and short firms with low options-implied returns. Numerous exercises and robustness checks confirm options’ strength of information content. It would be similarly interesting to examine the predictive strength or weakness of futures markets and the ability to derive a similar strategy to the one that the authors propose. The different underlying instruments in this domain along with their volatility determinants would make for interesting, yet challenging, research.

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