Options Education: Time Decay
I am on the hunt for a short volatility position for three main reasons.
First, the market’s wild swings have, for the time being at least, diminished.
Second, option activity has dried up as my barometer continues to be stuck in the 4 – 6 range as traders are not making big bets in either direction. This leads me to believe the market may be stuck in no-man’s land.
And third, we are coming up on a double whammy for options prices. Here is what I mean by that:
As I have written in the past, options prices get hit hard as one expiration cycle expires and a new options expiration becomes the front month. And this week, January options will cease to exist, and February options will be the front month.
The reason for this? Let’s say you were long stock in Facebook (FB) and short a January call against it. This is the typical buy-write/covered call position. As the January call you are short expires you would look to sell a new call against your FB stock position.
However, Jacob the market maker knows that this trade is coming from individual traders and from institutions. So, as the market maker, I would start lowering the price of the February options ahead of time so that I will be buying at a cheaper price when others are selling.
Then, on top of that throw in the upcoming long weekend.
The stock market will be closed on Monday, January 21st for Martin Luther King Day—a nice three-day weekend. But it’s not generally good for options prices.
Over the course of the next couple of days, the market makers, or more likely their computer systems, are going to “push the date ahead” in all their products. So in the market makers’ pricing models, tomorrow’s date won’t be January 17th, it’s more likely to be January 21st.
And as we get closer to this weekend, the computer models will move the date to January 22nd, which is the day the market opens after the holiday. The models do this to price in the decay of the day off for the holiday. That means that they will take virtually all of the decay out of the options ahead of time so that they aren’t stuck being the buyer of decaying assets over a long weekend.
So how do we profit from this phenomenon? By selling options via buy-writes or option spreads.
When we sell options, we are trying to capture the option decay as we are short a decaying asset.