Too Good to be True? An Analysis of the Options Market's Reactions to Earnings Releases

Abstract

Using option implied risk neutral return distributions before and after earnings announcements, we study the option market's reaction to extreme events over earnings announcements. While earnings announcements generally reduce short‐term uncertainty about the stock price, very good news does not reduce uncertainty and slightly bad news actually increases uncertainty. We also find that left tail probabilities decrease over earnings releases while right tail probabilities increase. We interpret these findings as evidence of maintained investor expectations that very good news is generally not released during earnings announcements, combined with skepticism in the form of lingering uncertainty at the release of such very good news.

Asymmetric impact of earnings news on investor uncertainty

“…() and Pastor and Veronesi () takes effect in this region, as investors may infer lower precision of extreme earnings news. This result may also be consistent with the interpretation in Lu and Ray () that extremely positive earnings news raises market scepticism. Regardless, the cause for this reversal is beyond the scope of this study.…”

“…This result may also be consistent with the interpretation in Lu and Ray (2016) that extremely positive earnings news raises market scepticism. Regardless, the cause for this reversal is beyond the scope of this study.…”

Time‐varying impacts of expectations on housing markets across hot and cold phases

“…Also, for large favourable shocks, the results suggest a “too good to be believed” pattern; the GTTB shows almost no response to uncertainty shocks in both regimes. Interestingly, the results regarding the limited responses of people's expectations to both varieties of large shocks provide implications of behavioural finance for housing markets, and they partially complement the argument by Lu and Ray (2016). Differentiating small (slightly) from large (very) bad or good news, they address options prices' responses to earnings announcements.…”

“…Differentiating small (slightly) from large (very) bad or good news, they address options prices' responses to earnings announcements. Lu and Ray (2016) propose the findings that release of large bad news could reduce price volatility, but extremely good news does not resolve much uncertainty owing to scepticism at large good news. Interestingly, while Lu and Ray (2016) suggest that the scepticism phenomenon exists for large good shocks solely, this study yields more evidence supporting the phenomenon's existence for both bad and good news.…”

Informed options trading prior to FDA announcements

“…Our findings contribute to the growing body of literature that reports the abnormal behavior of returns, volume, open interest and implied volatility spreads/skew in stock and options markets around major corporate announcements. For example, around earnings releases (e.g., Bohmann et al., 2019a; Lu & Ray, 2016; Tsai, 2014; Udpa, 1996), mergers and acquisitions (e.g., Bugeja et al., 2015; Cao et al., 2005; Chan et al., 2015), repurchases (e.g., Hao, 2016), stock splits (e.g., Chern et al., 2008), management forecast disclosures (e.g., Cairney & Swisher, 2004), bankruptcies (e.g., Cheng et al., 2018) and large price changes (e.g., Patel & Michayluk, 2016b; Savor, 2012). Holistically, the literature suggests informed trading in options markets is a pervasive issue.…”