Taking the Day Out
When the number of days to expiration used in the pricing model declines
from, say, 32 days to 31 days, the price of the option decreases by the
amount of the theta, all else held constant. But when is the day “taken out”?
It is intuitive to think that after the market closes, the model is changed to
reflect the passing of one day’s time. But, in fact, this change is logically
anticipated and may be priced in early.
In the earlier part of the week, option prices can often be observed getting
cheaper relative to the stock price sometime in the middle of the day. This is
because traders will commonly take the day out of their model during
trading hours after the underlying stabilizes following the morning
business. On Fridays and sometimes Thursdays, traders will take all or part
of the weekend out. Commonly, by Friday afternoon, traders will be using
Monday’s days to value their options.
When option prices are seen getting cheaper on, say, a Friday, how can
one tell whether this is the effect of the market taking the weekend out or a
change in some other input, such as volatility? To some degree, it doesn’t
matter. Remember, the model is used to reflect what the market is doing,
not the other way around. In many cases, it’s logical to presume that small
devaluations in option prices intraday can be attributed to the routine of the
market taking the day out.