Nothing happens in financial markets on most weekends. So an options trader will sell call options and put options and try to earn the time value decay for three nights — Friday Night, Saturday night, Sunday night. If it is a long weekend, the selling will be more, because of more time value decay.
Due to selling, call and put option prices will decrease. This also results in a lower Implied Volatility on weekends, compared to weekdays.
This phenomenon is called “Weekend Effect”.
However, IVs are restored close to normal on the next market day.
Example
December 2017 expiry is on 28th December. 22nd December 2017 was a Friday.
25th Monday was Christmas. The market opened on Tuesday, December 26 after a long weekend.
NIFTY December future was unchanged, just 1 point up, so nothing changed over the weekend.
Here are the December options and IVs on Friday, 22nd December 3:30 PM and Tuesday, 26th December 1.30 PM.
10500 Put closed at 46 Rs on Friday and dropped by 9.7 Rs to 36.25 Rs on Tuesday.
So an option seller did make some money as nothing changed over the weekend.
But did he make money for 4 nights?
To answer this we must find out Theta, or the decay in option price per day.
Theta
Theta on 10500 Put on Friday evening was 4 Rs, and 6.22 on Tuesday afternoon.
Average Theta on the 4 day period = 5.1
The seller got around 10 Rs, that’s 2 days of theta.
Friday 3.30 to Tuesday afternoon is roughly 3.75 days.
Decrease in option price due to decay = 3.75*5.1 = 19.125 Rs — that did not happen. Just 10 Rs drop happened.
Where did the extra 2-day theta go? That is explained by Vega
Vega
Vega is the change in option price with 1% change in volatility.
Vega was 5.3 Rs on Friday and 3.5 Rs on Tuesday afternoon. Average = 4.4 Rs
IVs jumped up 2.3% on 10500 Put.
Increase in option price due to Vega = 4.4*2.3% = 10.1 Rs
Theta + Vega
Theta Loss + Vega Gain = -19.125+ 10.1 = -9.1
There is a 50 paisa decrease because index moved up 1 point.
Adding that, the theoretical change in option price is calculated as 9.6.
That is close to 9.7 which is the difference between option prices on Friday and Tuesday. Voila! Theory works!
Takeaways
- Option math is really cool :)
- If you sell on a weekend and nothing happens over the weekend you will gain money on the time value decay. This works better close to the expiry.
- However, you will not get a 3-day Theta because if you sell on Friday evening, you will only get around 1 day Theta. That is because, by the time you sell on a Friday evening, a lot of people have sold and reduced the price and IV of the option. This IV will come back on Monday morning, which offsets your Theta gain a little as Vega Loss.
- Sell at the money options to get the highest Theta
- Sell equal amounts of at the money calls and puts, to maintain direction neutrality
- And if you do not want to do any of this math, and jump right into finding out Theta by just moving a slider, try Option Trade Analyser by Sensibull
- If you would like to find out the Theta of any complex strategies like calls, puts, call spreads, put spreads, straddles, strangles, iron condors, iron butterflies, etc you can do it on Custom Strategy Builder by Sensibull — India’s first Options Trading Platform
