Night Terrors

Following on from my recent posts about trading volatility over weekends, I’m now going to briefly look at trading options overnight.

Option traders have always complained when they were too long options overnight, expecting to usually lose money on overnight longs. This doesn’t make sense in a pure Black-Scholes-Merton world. In that world the time decay (theta) will be balanced by the expected change in the underlying (gamma). But we have already seen that this doesn’t hold over weekends.  So while option traders might be the whiniest group of trading professionals and are more than willing to complain about anything (I’ve heard such classics as, “I hate summer” and “Christmas is literally the worst thing ever”), it is worth examining whether they were right about this particular thing.

Dmitriy Muravyev and Xuechuan Nia wrote a paper that studies this.  While it is very well known that returns to index options are negative (about -0.7% a day in terms of actual premium decay for the S&P) it turns out that all of this comes from overnight decay. Specifically, delta-hedged option returns are -1% overnight, while intraday returns are positive at 0.3% per day.

On its own this won’t actually lead to a good trading strategy. If we to buy options every day and short them overnight the trading costs would be prohibitive. But it tells us where the variance premium comes from. We get paid for taking the risk of illiquidity, for having a bet that we can’t get out of if it goes against us.

Or else people are afraid of the dark.