The Weekend Effect … Effect

Hey Traders,

As a VIX trader, you have to be aware of the weekend effect.

It’s a phenomenon caused by the fact that the option pricing model assumes constant deca, but … we only trade five days a week.

And last week, thanks to a holiday, we traded just four days.

Let me explain…

Heading into Thursday’s close, traders knew that there was going to be three days of closed markets.

Do you think market makers were going to simply close up shop on Thursday night and walk in on Monday with all their options down three full days of decay?

The April30 SPX at-the-money option (the front contract that is in the VIX calculation) closed on Monday at $56 per contract.

That contract has a theta decay of $118 per day. Theta is the “Greek” that measures the change in an option’s value for every day closer to expiration. It essentially measures time value.

Anyway, that $118 figure means if the market makers don’t do anything about the weekend, on Monday they would have lost $360 per contract (!) that they were long …

Market makers are smarter than that. (I should know — I used to be one!)

Throughout the week, traders who pay attention will notice that options actually decay MORE than their allotted daily decay …

How much?

On a normal week, the extra decay will equate to about 1.50 additional days of decay.

That means you can take the theta number and multiply it by 6.5/5.

So if I have a daily decay of $120, the actual decay that will come out of my option is (120*6.5)/5 — or about $155 per day.

This is done so that traders can “decay out” the weekend throughout the week.

While the process is slightly more nuanced than how I explained it, that is basically what market makers do.

But here’s the thing …

The VIX does not know market makers are doing this to options.

Instead the VIX reads that the options are losing volatility (rather than theta) …

Thus, historically and statistically, the VIX goes down four days a week.

The only day the VIX is up statistically is Monday.

This is because it is the one day of the week the VIX model and option market makers pricing are aligned.

So why am I telling you this?

Because while the VIX was up .58 yesterday, the VIX was essentially down.

Coming off of a long weekend, the VIX, all things being equal, should be up about one full point.

The VIX only being up .58  says to me that it’s pretty much down.

Now, midday on Monday, when the VIX was up over a point and the SPX was up 60, that was a different story. VIX was fractionally up (something I don’t like when SPX is up almost 2% because volatility should drop as the market rallies).

But that fizzled and VIX ended, weekend adjusted, down a touch.

Folks, this is why VIX correlation is NOT the No. 1 factor on the Option Pit VIX Light …

The VIX curve is.

VXX was off over 2.5% yesterday …

The VIX futures were down yesterday …

To me, especially on a Monday after a long weekend, that paints a MUCH clearer picture. Because unlike the VIX, the futures trade almost constantly and do not have the issues associated with “weekend decay."

The Option Pit VIX Light Is Red, and Volatility Is Likely to Drop.

Your Only Option,

Mark Sebastian

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