Option Sellers Can Profit From Mother Nature’s Wrath

by Tyler Craig | October 31, 2012 6:30 am

Option Sellers Can Profit From Mother Nature’s Wrath

Unscheduled market closings are a rarity. According to DealBook[1], this week’s market stoppage due to Hurricane Sandy “is the first weather-related closure of the American stock markets since Hurricane Gloria in 1985. And it is the first unscheduled trading stoppage since the Sept. 11 terrorist attacks.” Of course, while the impact of such market shutdowns may be muted for stock traders, they do have some interesting implications for those of us playing in the options arena.

Although prices have stood still for days as Mother Nature unleashed her fury on the East Coast, Father Time continued his mission uninterrupted. Remember: Option contracts have a finite life. With their death date known from inception, each day brings them closer and closer to the inevitable end. As time passes, options lose a bit of value — a phenomenon otherwise known as time decay.

The option Greek that measures an option’s sensitivity to time decay is theta. Theta can be properly characterized as a dirty little thief who steals from option buyers. Of course, not all options are equally vulnerable to theta’s predatory antics. Because of the acceleration of time decay, theta steals the most amount of money during the last few weeks or days prior to expiration.

For example, with Apple (NASDAQ:AAPL[2]) trading at $604, the November weekly 605 calls set to expire this Friday have a theta of -88. In contrast, the December 605 calls only possess a theta of -24. The weekly options are losing 3.5x the amount of money each day because of time decay.

While theta might be viewed as the enemy of option buyers, option sellers count it as one of their most dependable allies. Indeed, the ability to profit from time decay is one of the primary reasons traders sell options to begin with. Put simply, the money lost by option owners due to time decay goes directly into the pockets of option sellers.

If there is one group of market participants set to profit the most from Hurricane Sandy, it’s these guys. The weather might be able to halt price movement for a few days, but it certainly can’t stop the clock from ticking.

Consider the unfortunate plight of those who purchased the aforementioned weekly AAPL call option in hopes of exploiting a quick rise in the stock. Their bet is that the stock will lift enough to offset the $88 of time decay eating away at the value of the option each day. Well, guess what? By the time the market reopens today, these unlucky option buyers will already be two days behind. The full five days they originally thought they had for AAPL to make its move have whittled down to three.

The bottom line: Unscheduled market closings, though rare, provide an unexpected boost to anyone possessing short option positions.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

Endnotes:
  1. DealBook: http://dealbook.nytimes.com/2012/10/29/u-s-markets-to-be-closed-on-tuesday/?src=un&feedurl=http://json8.nytimes.com/pages/business/index.jsonp
  2. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL

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