The effect of option transaction costs on informed trading in the options market around earnings announcements

We investigate the effect of option market transaction costs (a form of market imperfection) on the ability of option implied volatility-based measures to predict future stock returns and volatility around quarterly earnings announcements. We find that the predictability is significantly stronger for firms with lower option relative bid-ask spreads. The effect is more pronounced around positive rather than negative earnings news. We find no significant effect of option transaction costs around randomly chosen dates when there is no clustering of major information events. Trading strategies based on option market predictors and transaction costs earn monthly abnormal returns of 1.39% to 1.91%.