Thanks to everyone who participated in Friday's “Question of the Day”. The correct answer was “C” and the key to it lies in the sharp decline in implied volatility (IV) and the effect that Theta (or time value) has on options value as it approaches expiration.
For this question, we purposely chose an extremely elevated IV at the initiation of the position to simulate a situation wherein there was extreme uncertainty over an event such as an OPEC meeting, causing options sellers to increase the premium they were demanding. Remember, as we’ve discussed many times in In FOCUS, the higher the IV, the higher the price, all else equal. In this case, the elevated IV resulted in a premium of .15 for an option with only 2 days until expiration and a strike price nearly 5% higher than the current price. In our hypothetical example, the futures price did rise, as the trader expected, but by about 3% and because the OPEC decision removed much of the uncertainty from the market, implied volatility fell by almost half. In order to illustrate just how elevated the premium of the option was because of the implied volatility, if we changed the implied volatility on the day we initiated the position from 52% to the level it was the next day, 27%, the theoretical value of the position at initiation would have been .01 ($10) instead of .15 ($150).
The theta, or value associated with time left to expiry, tends to become larger in absolute value terms as most options approach expiration. For long options, the Theta tends to become “more negative”, as each day that passes will cause greater “time decay”. In this case, with a theta value of -.11, if we held everything else equal from the day we initiated the position to the following day, the option would theoretically be expected to lose .11 of the .15 initial value. However, the value of the option fell to .08 and not .04 (or lower) because the positive delta partially offset the Time and Volatility effect as the price of the futures rose.
We show the QuikStrike analysis of the “Before” and “After” below.
Obviously, this was a theoretical example meant to underscore the importance of implied volatility in options trading. We’ll continue that exercise in theory with the following alternative example. Assume that a Put with a comparable delta on the Wednesday of this hypothetical example was trading at a similar implied volatility. A trader who wanted to assume a speculative long position could, theoretically, sell a Put instead of buy a Call, to take advantage of the elevated volatility level. Of course, if they only sold the Put, they would be subject to unlimited risk if the price of the underlying future fell after the OPEC report was released, in our example. So, we put together a theoretical position that involved selling a Put with a comparable delta and IV and simultaneously buying a lower delta Put in order to define the risk in the trade. Doing so, resulted in a collection of premium of .12 or $120.00. If we then make the same hypothetical adjustments we made in the original example to price and volatility, the value of that position approaches zero or, in other words, the trader would have, theoretically, made the $120.00 they collected.