Hey everybody, Butler here from the tastylive Research Team.
When a new trader learns about the option Greeks, there’s often a common misconception about Theta. Since theta represents an option's theoretical decay with the passage of a day, it seems logical that selling an option on a Friday and buying it back on a Monday would be a good trade, as you can collect the theta of those weekend days when the market is closed.
However, this trade is not a very viable strategy, as the market generally prices in the weekend theta prior to the weekend.
In order to test the effectiveness of trading for weekend theta, we had to isolate weekends in which the market moved very little. We found 46 occurrences in the past 3 years where the S&P 500 moved less than .01% over the weekend. Then we tested selling a straddle on the market close prior to these weekends, and closing them on the market open after the weekend. We compared the P/L on these trades to the expected P/L as predicted by Theta.
We also ran the same test on normal market days where the market did not move. The idea being that over the course of a normal day, the P/L on a short position would be much closer to the theoretical decay as stated by theta.
The findings of this study confirmed that even if you knew the market wouldn’t move over the course of a weekend, your P/L will be significantly less than your projected P/L based on theta. 57% less profit than theta predicted, in fact! '
Furthermore, in the occurrences where we tested the decay over the course of a normal trading day, and not over a weekend, the ending P/L actually exceeded the expected theta by 59%!
If you want to look at this research some more, go to the full archive here. Be sure to check out all the great information in the show archives. So much research!
OK, I’m Chris Butler. Thanks for watching this Market Measures Notebook!
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