Overreaction to Stock Market News and Misevaluation of Stock Prices by Unsophisticated Investors: Evidence from the Option Market

Abstract

This paper examines option activity on value and growth stocks before earnings announcements. The main finding is that unsophisticated investors enter option positions that load up on growth stocks relative to value stocks in the days leading up to earnings announcements. This occurs despite the fact that at earnings announcements value stocks outperform growth stocks by a wide margin. The paper's results provide evidence that unsophisticated option market investors (1) overreact to past news on underlying stocks and (2) mistakenly believe that mispriced stocks will move even further away from fundamentals at impending scheduled news releases.