Theta and Weekends Again

Last week we stated that market makers don't fully account for weekend decay in equity options. Today we show specific results.

Christopher Jones and Joshua Shemesh studied this issue and presented the findings in a paper that they presented to the 2010 American Finance Association meeting. They looked at the returns of long option portfolios on U.S. equities from 1996 to 2007 and found the average return over the weekend was negative (0.62% of the portfolio value) while the returns for all other days were slightly positive (0.18% a day). It is important to be clear what these numbers mean. The 0.62% number means the average option (averaged over puts, calls, and all strikes and maturities) declines in value by this amount over the weekend. This is not the return on equity of a trader holding a short position. This position would need to be secured by an amount of margin that is appreciably greater than the option premium.

Having established that weekend returns are significantly lower than those of other days, the authors went on to study other holidays, including long weekends. Their hypothesis was the effect was directly related to non-trading, which would imply lower returns would also be associated with other holidays, and the effect would be stronger over long weekends. This all seems to be true: Returns on equity options are negative whenever the market is closed. It seems the effect exists because market makers are not correctly adjusting the implied volatilities on Fridays to account for the upcoming weekend.

Although the size of this effect in dollar terms might seem minimal, it is significant for several reasons. First, there is no general edge in selling stock options (unlike index options, where being short is normally the way to lean), so it represents a totally new effect, rather than a matter of timing an entry. The dollar amount of the effect grows with volatility, and the strategy-based margin actually decreases slightly, so returns will be better in high-volatility environments. This behavior was consistent across years and was robust with respect to exactly how the portfolios were constructed.

The researchers didn’t find a similar effect in index options but next week I will show how something similar can be done in the index space.