Earnings announcement impact on european options pricing: a trading strategy development

undergraduate thesis

• Author: Mahmoud Ahmed
• Mentor: Josip Arnerić (mentor)
• Granter: University of Zagreb; Faculty of Economics and Business; (Department of Statistics); Zagreb
• Defense date and country: 2024-09-16, Croatia
• Scientific / art field, discipline and subdiscipline: SOCIAL SCIENCES; Economics; Finance

Abstract

This paper examines the effect of earnings announcements on European options pricing, focusing on developing a trading strategy that exploits market inefficiencies, specifically the earnings surprise anomaly. The study is grounded in the Efficient Market Hypothesis (EMH), which claims that market prices incorporate all available information. However, it identifies anomalies such as the earnings surprise, which occurs when unanticipated earnings announcements lead to price movements not reflected in the market. The research is divided into several key sections. First, it reviews the literature on earnings surprises and the Post-Earnings Announcement Drift (PEAD), where stock prices tend to move toward the surprise after the announcement. Second, it explores the impact of earnings surprises on options. It uses key risk measures—delta, gamma, theta, vega, and others—to explain how these metrics influence options' value and risk profile. Building on this analysis, a trading strategy is proposed. This strategy involves identifying companies likely to report positive earnings surprises, constructing options positions that maximize returns from these announcements, and managing risk through the use of options Greeks. The strategy focuses on slightly out-of-the-money call options with a specific delta range and high volatility, timed to capture the early effects of PEAD while mitigating post-announcement volatility crush. The paper highlights that while such strategies are commonly employed by hedge funds, individual investors can replicate this approach to improve their portfolio’s performance. Emphasis is placed on risk management, diversification, and the potential to enhance the risk-return trade-off by combining systematic returns with alpha generated from market inefficiencies. The study concludes by suggesting that future research could focus on backtesting the strategy and exploring other anomalies for alpha generation.

Abstract (english)

This paper examines the effect of earnings announcements on European options pricing, focusing on developing a trading strategy that exploits market inefficiencies, specifically the earnings surprise anomaly. The study is grounded in the Efficient Market Hypothesis (EMH), which claims that market prices incorporate all available information. However, it identifies anomalies such as the earnings surprise, which occurs when unanticipated earnings announcements lead to price movements not reflected in the market. The research is divided into several key sections. First, it reviews the literature on earnings surprises and the Post-Earnings Announcement Drift (PEAD), where stock prices tend to move toward the surprise after the announcement. Second, it explores the impact of earnings surprises on options. It uses key risk measures—delta, gamma, theta, vega, and others—to explain how these metrics influence options' value and risk profile. Building on this analysis, a trading strategy is proposed. This strategy involves identifying companies likely to report positive earnings surprises, constructing options positions that maximize returns from these announcements, and managing risk through the use of options Greeks. The strategy focuses on slightly out-of-the-money call options with a specific delta range and high volatility, timed to capture the early effects of PEAD while mitigating post-announcement volatility crush. The paper highlights that while such strategies are commonly employed by hedge funds, individual investors can replicate this approach to improve their portfolio’s performance. Emphasis is placed on risk management, diversification, and the potential to enhance the risk-return trade-off by combining systematic returns with alpha generated from market inefficiencies. The study concludes by suggesting that future research could focus on backtesting the strategy and exploring other anomalies for alpha generation.

• Keywords: Earnings Announcement; European Options Pricing; Efficient Market Hypothesis (EMH); Market Efficiency; Earnings Surprise; Post-Earnings Announcement Drift (PEAD); Market Anomalies; Systematic Risk; Alpha Generation; Hedge Funds; Options; Greeks; Delta; Gamma; Theta; Vega; Risk Management; Options Trading; Call Options; Volatility Crush; Market Inefficiencies; Portfolio Management; Idiosyncratic Returns; Capital Asset Pricing Model (CAPM); Markowitz Portfolio Theory; Trading Strategy; Risk-Return Trade-Off; Systematic Returns; Diversification; Beta; Lambda; Option Volatility; Volga; Backtesting; Inflation Illusion Hypothesis
• Keywords (english): Earnings Announcement; European Options Pricing; Efficient Market Hypothesis (EMH); Market Efficiency; Earnings Surprise; Post-Earnings Announcement Drift (PEAD); Market Anomalies; Systematic Risk; Alpha Generation; Hedge Funds; Options; Greeks; Delta; Gamma; Theta; Vega; Risk Management; Options Trading; Call Options; Volatility Crush; Market Inefficiencies; Portfolio Management; Idiosyncratic Returns; Capital Asset Pricing Model (CAPM); Markowitz Portfolio Theory; Trading Strategy; Risk-Return Trade-Off; Systematic Returns; Diversification; Beta; Lambda; Option Volatility; Volga; Backtesting; Inflation Illusion Hypothesis
• Language: english
• URN:NBN: urn:nbn:hr:148:525049
• Study programme: Title: /; Study programme type: university; Study level: undergraduate; Academic / professional title: sveučilišni prvostupnik (baccalaureus) ekonomije/sveučilišna prvostupnica (baccalaurea) ekonomije (sveučilišni prvostupnik (baccalaureus) ekonomije/sveučilišna prvostupnica (baccalaurea) ekonomije)
• Type of resource: Text
• File origin: Born digital
• Access conditions: Open access
• Created on: 2024-09-17 19:13:33