Thursday is a long way away from Monday's opening. Many who sell premium think of that long expanse of time as the weekend nears. They are thinking about selling premium by entering new positions. Trades such as credit spreads, iron condors, butterflies and calendars all involve sold options. They're also positive-theta trades, meaning that the trader who initiated the trade benefits by the passage of time. Traders want to capture that weekend decay by entering their trades at the end of the week.
Only, the options market markets know that. They know it better than we do, watching the premium sellers start hitting them with orders. We think we're so smart. Options market makers know they'd better be smarter.
That fact was first brought to my attention several years ago by a woman in my trading group who had just listened to a presentation by someone on her trading platform. By midday Friday, market makers have already priced in much of the weekend premium decay, she warned me. If we intended to place our iron condor orders before the weekend, we perhaps needed to get them in by early Friday morning.
Or even earlier, former market maker and current mentor with Sheridan Mentoring, Mark Sebastian, has warned. On a quiet week, market makers will begin pricing out that weekend decay even sooner than Friday afternoon, Sebastian warns. By Friday afternoon, only one day of decay, that from Sunday night to Monday morning, has been left. Otherwise, we'd all be gleefully selling premium on Friday afternoon and buying it back Monday morning, three days' worth of decay happily pocketed, to the detriment of the market maker taking the other side of the trade.
How would a market maker price out the weekend decay like that? Some factors that go into an options' price are immutable, at least by the market maker. The market maker can't change the underlying's current price, the options' strike, the current interest rate, and the days to expiration. But what isn't so immutable is the implied volatility, which is, after all, an estimation of future volatility. Under the right conditions, this is what the market maker can change in the pricing model. At least when trading is quiet, implied volatility can gradually be lowered over several days or hours of trading, and the options' prices will lower, too. Premium sellers won't get to sell as much of that extrinsic or "time value" as they expected. When they run their trades through a pricing model and calculate how much they're going to be ahead on Monday morning when the markets open, they may be surprised come Monday morning.
Thinking about that idea, I began wondering how many times volatility might be down on Fridays.
Annotated Daily Chart of the VIX:
The blue arrows mark Fridays when the VIX closed lower than its open, with the exception of the first two blue arrows, which also mark the Wednesday and Thursday leading into Labor Day weekend. Sebastian warns that in a quiet week leading into a long holiday weekend, that "marking down" process may begin by midweek. The red arrows mark Fridays when the VIX closed above the open.
The candles were fairly equally distributed, but we have to keep in mind the market action, too. On October 30, for example, markets plummeted after a weak University of Michigan Consumer Sentiment survey, Personal Income and Spending report. A market maker would be unable and probably unwilling to lower volatilities on a day like that, when many options traders were coming into the market not to sell premium but rather to buy puts to protect positions or participate in the bearish action.
So, I don't think we can necessarily study a chart of the VIX and verify Sebastian's observations. Market action may mean that, instead of being overwhelmed by premium sellers, market makers are overwhelmed by option buyers. Yet, we still can take his word and those of the long-ago presenter that my trading friend heard via her trading platform. We've now heard from two sources that, given the opportunity, market makers will start pricing out most of the weekend decay by midday Friday and maybe even sooner, especially in a quiet week leading up to a holiday weekend.
If you're a premium seller via strategies such as iron condors, butterflies, calendars, or other such strategies, hoping to open a new trade on a Friday and collect a whole weekend's worth of theta or time decay, you perhaps might consider this effect.
More importantly, however, if you're a trader who is holding onto a trade that's right on the edge of your maximum loss, take heed. If you're a trader whose theta-positive position has just reached planned profit, but you're thinking that the time decay over the weekend will bring you even more profit, also take heed. Perhaps you're running that trade through a theoretical profit/loss model such as those on think-or-swim, Options Oracle, BrokersXpress' option pricers or other such models. Perhaps you think that if you can just hold on through those three days from Friday morning to Monday morning, you can squeeze by and get out of a losing trade with a smaller loss or, in the case of the profitable trade, squeeze out even more profit. However, you're basing your decision on a theoretical model when it's possible that most of the weekend decay is already priced out. You're accepting a whole weekend of risk and you may not be getting the benefit you'd expected.
It's something to keep in mind, isn't it?