Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 28 Nov 2018

Earnings related trading: Futures or Options

There is a large body of literature (mainly in the US) that a lot of the trading activity in response to earnings information happens in the options market. (The seminal paper in this field is Roll, R., Schwartz, E., & Subrahmanyam, A. (2010). O/S: The relative trading activity in options and stock. Journal of Financial Economics, 96(1), 1–17.) Unfortunately, the US and most other countries do not have a liquid single stock futures market, and so we do not know whether the options market was the preferred choice of the informed traders or it was the second best choice substituting for the missing first choice (the futures market). If what the informed trader wanted was leverage and short selling ability, the futures are a much better vehicle because there is no option premium and no delta rebalancing cost. On the other hand, if the trader believed for example that there was a high probability of a large upside surprise in the earnings, counterbalanced by a more modest risk of downside surprise, then the sensible way to express that view would be with a bull-biased strangle (buy a substantial number of out-of-the-money calls and a somewhat smaller number of out-of-the-money puts). It would be too risky to trade this view in the futures market without the downside protection provided by options.

India provides the perfect setting to resolve this issue because it has liquid single stock futures and single stock options markets (both of these markets are among the largest such markets in the world). In a recent paper, my doctoral student, Sonali Jain, my colleagues, Prof. Sobhesh Agarwalla and Prof. Ajay Pandey and I investigate this (Jain S, Agarwalla SK, Varma JR, Pandey A. Informed trading around earnings announcements – Spot, futures, or options?. J Futures Markets. 2018. We find that in India single stock futures play the role that the options market plays in the US implying that the informed traders are seeking leverage benefits of derivatives rather than the nonlinear payoffs of options. We also find patterns in the data that are best explained by information leakage. Though, Indian derivative markets are often disparaged as being gambling dens dominated by noise traders, our results suggest that the futures markets are also venues of trading based on fundamentals.

Posted at 18:16 on Wed, 28 Nov 2018     View/Post Comments (0)     permanent link