Small and Large Trades Around Earnings Announcements: Does Trading Behavior Explain Post-Earnings-Announcement Drift?

Abstract

This paper analyzes trade-initiation by small and large traders for one year following earnings announcements and examines the predictive ability of event-time trading for future returns. With earnings surprises based on a seasonal random walk expectations model, small traders react slightly more weakly than large traders, during the event window, to the first surprise in a series of similar surprises, but more strongly than large traders to the later surprises. With earnings surprises based on analyst forecasts, small traders react more weakly than large traders regardless of the past series. Large traders trade in the direction of the earnings surprise for one month after the earnings announcement, while small traders do not. Starting in month two this switches and small traders trade in the direction of the surprise, while large traders do not. The strength of the small trade event-time reaction is a weak positive predictor of returns in the first month after the announcement and a weak negative predictor of drift after the first month. Large trade reaction is generally a negative predictor of future drift. The collection of evidence points to both small and large trader underreaction to earnings announcements, with small trader underreaction more severe in the first month. In month one, large traders capitalize on drift, but after that small traders seem to correct and possibly overreact.