Time Decay

 

I expect trading will be very quiet today ahead of tomorrow’s Jobs Report. This will be the last Jobs Report released before the September meeting of the Federal Reserve, a meeting that many traders are targeting for a potential interest rate hike.   

The Jobs Report will be released tomorrow morning before the market opens, and there’s the chance of a gap up/down if the numbers surprise investors. The options market is pricing in the potential of a 1.37% move tomorrow for the S&P 500, which is fairly priced or perhaps cheap in light of recent market volatility.

The market will be closed on Monday in celebration of Labor Day, so if the market does not make a big move tomorrow, the price of options will get hit extremely hard. Here’s a piece that I wrote in the past explaining why options lose significant amounts of value ahead of a long weekend:

Options Education: Time Decay

All options are a wasting asset whose time value erodes to zero by expiration. This erosion is known as time decay. Every day of an option’s “life,” it loses value as the time it has to finish in-the-money passes.

That said, let’s turn our attention to the calendar. The stock market will be closed on Monday, September 7 for Labor Day. This means that we have a three-day weekend. So what does this mean to options?

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, today’s date today isn’t September 3, it’s more likely to be September 6.

As we get closer to this weekend, the computer models will move the date to September 8, 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 or option spreads. 

When we sell options, we are trying to capture the option decay as we are short a decaying asset. 

That being said, if the computer models push the date ahead too far on Friday, I may take advantage of the cheap option prices and be a buyer of some options. 

Yesterday, as I was debating which strategy to use to put on a bullish Abbott Laboratories (ABT) position, I considered the upcoming volatility crush. Had I bought calls, I would have bought calls that could lose significant value over the long weekend. For that reason, I decided on a volatility selling strategy in an attempt to sell this quickly decaying option ahead of the computers. 

Similarly, I recommend not buying many options today or tomorrow ahead of the long weekend. If you need a hedge, don’t hesitate to buy puts. However, if the market or an individual stock does not make a big move tomorrow, expect options premiums to be hit dramatically.


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