06/05/2021 — Reverse Decay

Anyone with even the slightest understanding of basic options theory will tell you that the value of an option decreases over time. This is known and often referred to as “time decay.” As a greek parameter it holds the title of “theta,” and colloquially some will call it “burn,” but the basic idea remains the same — all things considered equal, an option will be worth less tomorrow than it does today.

It’s an oversimplification. It usually holds true, but what is really being discussed is an option’s “time value.” To no one’s surprise, a sharp move in a given direction can pump massive amounts of premium into an option, resulting in a large increase in value compared to the day before. Perhaps it’s better to say that the time value of an option always decreases over time.

That still makes time an incredibly powerful force with respect to pricing and trading. It would be tempting to name time as the most important factor in options trading. It would also be a mistake. Far simpler but infinitely more powerful, basic supply and demand still reign when it comes to options. There are no formulas, models, algorithms, or even years of wisdom and common sense that can trump market sentiment — however irrational or foolish it may seem.

This past week has been a frustrating reminder of this hard truth. Nearly everyday I would begin my trading routine by picking a range of strikes in which I would aim to cover some of my previous short sales. I chose this area based upon recent market movement (or lack thereof), days left to expiration, and my general urgency with which I needed risk protection. For the past few weeks this had meant taking a look at where options priced at a nickel were trading on the open, and picking a couple strikes a hundred or so points higher where I could place some bids. For expirations two days out, this strategy met with decent success. I found that my orders were routinely filled by the end of the day, giving me a couple nights of risk protection and better sleep.

Recently, the strategy has been as worthless as the puts I’ve been buying. In my mind, it appears perfectly reasonable that six hours of time decay in a stagnant market would provide an opportunity to purchase said puts at higher (closer to the money) strikes than the previous day. It seems to be a no-brainer. In reality, the past five days have exhibited the opposite behavior. Sometime in the early afternoon, far out of the money options begin to increase in value, not through market movement, and certainly not through time decay. How? Increase in demand.

Why? That’s a better question.

If people, firms, or computers all of a sudden decide that they want to buy, then you can disregard whatever your models and calculations may be telling you — demand will raise price. That’s easy enough to understand. Econ 101 applies here too. Shouldn’t most players be using pricing models that generally behave in a similar fashion? The market is farther away, there’s less time to expiration. Any sensible model would have these options priced lower, so from where is this demand coming?

It could be that there are a bunch of punters like me that need this same range of protection as part of their strategy. Perhaps there exist a few computer algorithms that implement a buy program when the market gets too high, or the volatility too low. Some savvy hedge fund managers or heads of trading firms might envision these points as buying opportunities. Then again it could be as simple as the risk departments of online brokerages calling up clients and forcing them to close positions before the end of the day.

Any of these are possible. Personally I tend to think it’s either triggered algorithms, or forced closures, with an occasional hedge fund play thrown in for good measure. I guess I’m biased against thinking there’s a ton of people out there doing what I’m doing…

In the end it matters little who is doing what and why. What matters to me is that my approach needs a bit of tweaking in this market. It may not exist, but recently it feels like I need to start factoring this faux-phenomenon of reverse decay into my volatility forecasting — at least if I want to reclaim my afternoons.

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A running soliloquy covering the life and times of a financial trader. Opinions, insights, commentary, and stories from past and present…served with a healthy dose of irreverence.

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Willie Witten

Willie Witten

Writer, thinker, trader, musician, builder and beer aficionado

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