There are multiple ways to deal with option pricing when major volatility expansion is triggered. The best way to deal with such scenarios is by plotting how options respond to changes in the underlying volatility and shifts in the time to expiry. Although there are 4 factors that impact options premiums, we shall talk about the impact of volatility expansion alongside a fixed rate of time decay.
We all know that OTM options lose major chunk of their value as time to expiry draws near. This is because; the premium of an OTM option is comprised of time value only. Therefore, shorter the time, faster the rate of decay. Let us consider two options, one expires in a week, and the other expires in a month. Now let us consider, the market is hit with excess volatility. The excess volatility should cause both the option premiums to expand. However, you will notice that the option with a shorter expiry will expand more than the one with the longer time till expiry. The important question is why.
In order to solve this, we need to first understand the concept behind this phenomenon. Volatility in simple words is the result of one standard deviation in the return of an instrument, in the shorter term. Therefore, it helps traders understand the magnitude of uncertainty of the future price movements. With expansion in volatility, the mathematical possibility of the instrument scaling up or plunging down increases. This is where a significantly surprising event takes place. The owner of the option with shorter expiry has a lower downside compared to the owner of the longer expiry. Therefore, the price of the option with the shorter expiry tends to be more attractive than its longer counterpart.
Live Example
Normally, expiries happen on Thursday but due to holiday on this Thursday (30th March), Wednesday happens to be the expiry. Do you know the rate of theta decay goes under significant change when a weekday is a holiday? In normal option parlance, theta decay should accelerate and that is what happened.
Friday itself (24th March 2023), premium indicated a strong range of 40,000 CE to 39,300 PE. The same was indicated in our weekly newsletter on 27th March. 40,000 CE and 39,300 PE of 29th March 2023 Expiry was sold collectively at 355 on 24th March 2023 and 700 pts OTM options on both sides were bought in the same expiry. The spread was initiated at a credit of 269. As we write this article, the spread is being covered at a credit of 28. That’s a whopping 241 points gain just by sitting patiently and hedging your risk completely. The sold calls, which I believe will be closed at 0.
If the same trade was to be taken by hedging the sold options by buying next week's options i.e., 6th April 2023 expiry. This trade would've been initiated with a debit of 153 and spread closed today at 265. A mere profit of 153 in comparison to 241 in credit one. This mechanism of choosing the strikes for hedging, whether it should be current week or next week is where your understanding of volatility and time value will come.
The current weekly contract was always the better bet provided the trader understands the impact of time value decay on both the contracts.