By Chris Ebert

stopwatchEvery trader has some sense of the passage of time. People who buy stocks are certainly concerned with how the prices of those stocks will move as time passes. However, even though stock prices tend to change with the passage of time, it is generally not the passage of time itself that causes the change in price.

For example, the fact that XYZ stock has risen 10% in the past year is not attributable to the passage of a year of time. Rather it is likely due to changes in perception regarding earnings, product development, demand from customers, institutional interest in the stock, as well as the overall environment for stocks. Essentially, those elements comprise the well-known CAN SLIM stock trading technique, and are often the ones that influence stock prices the most. Time is not one of those elements.

Stock prices do not generally rise at a predictable rate of, say, 10% per year. Such predictability is indeed available from instruments such as savings accounts, money market accounts and certificates of deposit. But stock prices are inherently un-predictable. Nobody can say, to 100% certainty, what any of the price-affecting elements of a stock will be a year from now, a month from now, or even a day from now. Thus, the stock price at any point in the future is always uncertain.

Some Background on Stock Options

A certain type of stock derivative known as a stock option is designed specifically for the purpose of addressing the concept of uncertainty. The price of any stock option, also known as the option premium, is based upon uncertainty. In general, the higher the amount of uncertainty, the higher the option premium will be. The option premium is derived from uncertainty in the stock price, hence the name: derivative.

There is a peculiar quality regarding uncertainly of the future – uncertainty tends to decrease as time passes; not always, but it is definitely the overwhelming tendency. Uncertainty surrounds all things in the future. While some things are fairly certain, for example, that the sun will rise tomorrow, others are less certain, such as the weather.

It is very likely that next Tuesday’s weather will be uncertain a week prior. As time passes, some of the uncertainty should disappear. Barometer readings, wind direction, cloud cover and temperature will all reveal clues that dispel some uncertainty as time passes. By the time next Tuesday arrives, all uncertainly will be gone. The weather will then be self-evident – anyone can simply take a look outside the window.weather

In much the same manner, uncertainty regarding stock prices tends to disappear as time passes. For example, the share price of XYZ stock next Tuesday will be less uncertain next Monday than it was the preceding Friday. By the time Tuesday rolls around, all uncertainty will have disappeared – anyone can simply open an appropriate window on a computer screen on Tuesday and the stock price will be self-evident.

All stock-option premiums are based on uncertainty surrounding a stock price on a specific day in the future – not necessarily next Tuesday – but a specific date known as the option expiration date. There will always be some degree of uncertainty as to what the actual stock price will be on that specific future date, until that date arrives. When the expiration date arrives, all uncertainty will have disappeared; the stock price will be self-evident.

Introduction to Option Time Decay

Since uncertainty regarding future stock prices tends to decrease as time passes, stock-option premiums tend to decrease as well. Option premiums tend to decrease with the passage of time. The decrease in premium is known as time decay.

Option Time DecayThe rate of time decay of an option depends on the amount of uncertainty remaining in the stock price. Uncertainty does not necessarily decrease in a straight line. In fact, uncertainty tends to decrease at an exponential rate, speeding up as time passes and as expiration day nears. Even so, uncertainty cannot be explained by a pure mathematical function. An exponential mathematical function merely simulates the overall tendency for options to experience time decay.

Uncertainty regarding stock prices involves many factors, the CAN SLIM elements being just the major factors among a slew of others. Any perceived change in a single factor or a combination of factors can affect the stock price. While some factors tend to change during market hours, others may change at any time of day, or any day of the week, even when stock markets are not open for trading.

Corporations may release earnings reports outside of the stock market’s regular trading hours. Products may be released outside regular hours as well. Each has the potential to move the stock price, and each has the potential to change the perception of uncertainty. Moreover, world events can change the entire market environment, leading to changes in uncertainty for all stocks. Given that world markets operate in different time zones, a major event that occurs during regular trading hours in one market may occur at a time of day when another market is closed. For example, markets in Asia are typically open when North American markets are closed.

Stock Price Gaps and Option Time Decay

The end result of the difference in time zones is that stock prices can change overnight, even when the respective market for those stocks is closed. These changes cause a gap in the stock price. The stock price at the end of trading one day can sometimes be much higher or lower when trading resumes the following day. In the case of stock market holidays or weekends, the resumption of trading may occur several days later. Price gaps can and do occur after holidays and after weekends, just as they do overnight.

Because stock prices can change overnight – stock prices can gap up or gap downstock options must experience time decay at night, even though the market is closed. Additionally, options must experience time decay on holidays and on weekends. Time decay does not stop just because the markets are closed. Time decay occurs purely as a result of a decrease in the perception of uncertainty; and uncertainty tends to decrease with the passage of time, regardless of whether or not a specific market is open. Price Gap

Nighttime option time-decay simply reflects the decrease in uncertainty that occurs at night. Holiday and weekend time-decay likewise represents the decrease in uncertainty that occurs during those time frames, when most markets are closed for trading.

A simple way of visualizing the effect is to think of a stock price that might be negatively affected by an earthquake. Certainly an earthquake can occur at any hour of the day or night, weekday or weekend. There will always be uncertainty at sunset that an earthquake could negatively affect the stock price before dawn. But as dawn approaches without an ensuing earthquake, that uncertainty disappears. The chance of an earthquake causing an overnight gap in the stock price decreases to zero as dawn approaches. Uncertainty decreases with the passage of time.

Risk-Free Profit in Absence of Overnight, Holiday, Weekend Time Decay

To prove that options must experience time decay at night, as well as during market holidays and on weekends, one need only consider the effect of a gap in the stock price on a specific type of option strategy known as a Delta-neutral Long Straddle.

A Delta-neutral trade is one in which the direction of the stock price is not a concern. True Delta-neutral trades experience no initial effect, regardless of whether the stock price moves up or down. One way to visualize the initial effect of a Delta-neutral trade is to picture a trader who is long 100 shares of XYZ stock and also short 100 shares of XYZ stock, at the same time. Whatever profit the trader experiences on the 100 long shares, as the stock price rises, will be exactly offset by a loss on the 100 short shares. Whichever way the stock price moves, the trader experiences no net gain or loss. The trader is Delta neutral.

In a Delta-neutral Long Straddle, the trade is initially Delta-neutral, but only remains Delta-neutral as long as the stock price remains stationary. Any change in the stock price, in either direction, has the potential to cause the trade to become profitable. A change in the stock price causes the Long Straddle to take on a bias in the direction of the move – the Long Straddle is no longer Delta neutral but instead has the potential to profit in the direction of the initial move in the stock price. In other words, the Long Straddle premium will tend to increase as long as the stock price keeps moving in the same direction.

In order to achieve a profit, the premium on the Long Straddle must increase, and it must increase sufficiently to overshadow the effect of time decay. If there was no time decay, any move in the stock price, no matter how small, would result in a profit on the Long Straddle. Since stock prices can and do experience gaps overnight, on holidays and on weekends, a Long Straddle would always be profitable during those gaps if there was no time decay to offset the increase in premium.

Delta Neutral Long Straddle

That is a profound characteristic to note: Absent time decay, a Delta-neutral Long Straddle will always be profitable during an overnight, holiday or weekend gap in the stock price. Since gaps are not uncommon (gaps occur practically every day in at least a few stocks, and sometimes occur on almost every stock in a single day) it would be possible, in the absence of time decay, to earn risk-free gains, practically every day, day after day, by opening Delta-neutral Long Straddles on large numbers of stocks.

Overnight, Holiday, Weekend Time Decay Must Always Exist

The market does not tolerate risk-free gains (risk free implying the trade returns a gain, after inflation, without risk of loss). Any source of risk-free gains would be considered the Holy Grail of trading, and once found would quickly be sought after by market participants from around the world. The source of the gains would eventually become insufficient to support the number of participants and the strategy would break down and eventually fail. No source of free money can exist indefinitely.

It should be noted that many types of instruments that are widely considered to be virtually risk free, for example government bonds, do not violate the rule because the gain is generally zero after being adjusted for inflation. There is no such thing as a free lunch – not for treasury bonds, not for stocks, not for options.

The fact that a stock price-gap will always result in a risk-free profit for a Delta-neutral Long Straddle option trade, in the absence of time decay, proves that such a trade cannot exist in the absence of time decay. There is no such thing as a risk-free profit, with the possible exception of arbitrage, and even arbitrage has its risks.

Option time decay must occur overnight, on market holidays and on weekends or else every Delta-neutral Long Straddle would be risk-free, and every Delta-neutral Straddle would return a risk-free profit from an overnight, holiday or weekend gap in the stock price. Since risk-free profit is not possible, and since time-decay is essentially the only consistent day-to-day risk for a Delta-neutral Long Straddle, time decay must occur at night, on market holidays and on weekends.

It should be noted that overnight, holiday and weekend time decay always occurs, but is not always observable. Poor option liquidity can obscure the effect of time decay, as can changes in implied volatility, upcoming dividends, and even changes in interest rates, to some degree. Nevertheless, the tendency is for time decay to occur constantly, whenever uncertainty is decreasing; and uncertainty always has a tendency to decrease with the passage of time regardless of whether the stock market is open or whether it is closed. Time decay never ceases!

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

 

Related Options Posts:

Thursday Evening Options Brief 26-Nov-2015

Sneak Peek at 2016 Options Market Stages

Option Alternatives for Stop and GTC Orders

Leave a Reply

You must be logged in to post a comment.