Understanding the Seasonality of Options
Those new to the world of options are often confused by the seasonality patterns that overlie option trades. These cycles occur both within each monthly cycle and in a yet larger pattern within each annual cycle.
One major monthly seasonality pattern results from nonlinear decay of extrinsic (time) premium. Each year has 12-monthly cycles. Since there are 52-weeks in a year, most cycles have 4-weeks duration. Each of these weeks has its own personality and understanding of the nuances can help a trader select a structure that will benefit from the tendencies of the particular portion of the cycle in which a trade is placed.
A classic characteristic of the last week of the option cycle is the ever increasing rate of decay of extrinsic premium. Jeff Augen has even gone so far as to characterize the breathtaking acceleration of option time decay during this period in his ground breaking book entitled Trading Options at Expiration: Strategies and Models for Winning the Endgame. For this reason, option structures that benefit from rapid time decay of premium work well in the last week of the monthly cycle.
As another example of seasonality within each of the twelve annual monthly cycles, butterflies become exquisitely sensitive to price movement during the last week of their life. Early in their life, butterflies are gentle creatures blowing gently in the currents of price oscillation.
As they age, minimal price fluctuations can have dramatic influences on their valuation as these gentle creatures become infected by gamma and forget their gently accommodative nature. For this reason, many experienced traders advise not allowing short butterflies to survive beyond the Friday before options expiration week. Long butterflies (with the short (middle) strike residing at-the-money) greatly benefit in this last week of life.
Other cycles have a more slowly oscillating pattern and are discernable in an annual time frame. Examples of such patterns would be the predictable decline in implied volatility during the summer vacation cycle and the Thanksgiving-Christmas holiday season.
Dan Passarelli is the author of the book Trading Option Greeks and founder and CEO of Market Taker Mentoring LLC. Passarelli began his trading career trading on the floors of the Chicago Board Options Exchange and the Chicago Board of Trade making markets in options. He regularly shares trading insights and educational tips in his options blog. Dan can be reached through his website https://MarketTaker.com and can also be followed on Twitter at twitter.com/Dan_Passarelli.
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