Options Forum: The End of Days

This article was originally posted June 10, 2004, and is being reprinted as a special bonus for TheStreet.com readers. Steve:

I would appreciate some background on a comment in a recent Columnist Conversation post where you said:

"The main impact of the shortened week is that options premiums got noticeably squeezed yesterday and today as most traders recalculate their pricing models to reflect one less trading day."

At first glance, this makes sense. But when I think about it a little, it's confusing. It seems to me that calendar days should be more important than trading days when it comes to valuing options premiums.

I think this because events that impact value happen even when the market is closed. Takeovers can be announced over the weekend. Commodity prices can change on the world markets. Terrorists can act ... or get caught. Executives can die. On this particular holiday, courts will still be open and could issue rulings with equity impact, etc.

Thank you,

-- W.

This is a great question that goes right to the heart of options pricing and valuation. The most commonly used method is the Black-Scholes, which considers five factors (price of the underlying security, strike price, time or expiration date of option, interest rates and expected or implied volatility) in calculating an option's theoretical price.

The reader makes a great point that calendar days certainly have a relationship to an option's value, but its impact actually becomes part of the implied volatility formula, not the time remaining. It's the number of days that an option is available to trade that is a more important factor in putting a time value on an option's price.

To put it simply: If you can never trade an option, it doesn't matter how much time is remaining -- for all practical purposes, it would be worthless. This is why many option traders choose to plug in trading days or work with 22-day months when pricing options; the days that an option can't be bought or sold are essentially worthless in terms of time value.

The market's close on Friday takes one day away from the option's trade availability. What if the decision had been to close for five days? Would you be willing to pay more or less for a decaying asset if you couldn't trade it during that time?

This doesn't mean that the possible events that the reader mentions can't occur, but they're the exception rather than the rule. They are unknown quantities, and as such their probability and impact would become part of the option's implied volatility calculus. But given that about 85% of all options expire worthless, most traders will use the general guideline that one less day of trading is one less day the stock price can change.