Do Options-Flow Signatures of Dealer Hedging Predict Price Direction Around Earnings?

Abstract

As investors trade options around a company's earnings announcement, the dealers who take the opposite side of the trade end up with exposure they didn't want, and normally offset it with an opposite position in the underlying shares. This mechanical hedging is not driven by investor sentiment, but may manifest itself as pressure on the short-term direction of a stock's price. This study combines four options-flow indicators (Volatility Smirk, Delta Difference, Open Interest Ratio, and Option Volume Ratio) representing four different types of dealer hedging pressure. Every indicator is referenced to a pre-earnings baseline specific to the ticker, and the four indicators are averaged into a composite indicator (Agg Score) that is weighted by each indicator's accuracy during the baseline. The model was tested on 30 earnings events from a stratified random sample of stocks across six sectors and a range of sizes, backtested with respect to the next-day price change direction on the 15 trading days around each earnings release. The composite achieved a hit rate of 48.16%, which was not significantly better than random (permutation test p = 0.740), and did not significantly outperform a naive momentum baseline (50.00%; McNemar p = 0.619) across 434 evaluations. None of the near- or far-from-earnings sub-periods, nor any single indicator, was significant, and accuracy was not focused around the time of the earnings release as predicted. These findings indicate that options-flow signals have little directional power around earnings, and that dealer hedging may impact volatility more than direction.