Thinking About Theta: An Analysis of Time Decay, Early Unwind and Closeout Feedback Effects

24 Pages Posted: 19 Apr 2017  

Anthony J. Seymour

University of Cape Town (UCT)

Florence Chikurunhe

Peregrine Securities

Emlyn James Flint

Peregrine Securities; University of Pretoria

Date Written: April 19, 2017

Abstract

Near-the-money options experience a rapid decline in time value over the weeks leading up to the expiry date. A possible strategy to alleviate the impact of the time decay effect is to unwind the hedge prior to expiry. However, appreciable time value is present for a reason: it is an indication that the final expiry value the option is uncertain and that there is a chance that the option could increase further in value.

In this work, historical data is examined in order to determine whether or not a South African equity index exhibits any abnormal behaviour prior to expiry that would affect one’s view on the likelihood of a hedge expiring in-the-money.

We present the results of analyses for two types of expiry-related effect in the local market, namely abnormal returns for periods immediately prior to expiry and price clustering where the underlying exhibits a higher probability of closing near a strike price on an expiry date.

We also discuss the historical performance of a strategy aimed at reducing exposure to time decay in a systematic manner in which a derivative strategy is rolled well before the expiry date. It is shown that for the period analysed, an investor who wished to roll a hedge every 3 months achieved an appreciable increase in realised return for a moderate increase in risk by rolling a longer term option every 3 months compared to holding a 3 month option for the full term.

Keywords: option theta, time decay, early unwind, option-expiry effects, option returns

JEL Classification: G11, G12, G13, G14, C15, C5, C6

Suggested Citation

Seymour, Anthony J. and Chikurunhe, Florence and Flint, Emlyn James, Thinking About Theta: An Analysis of Time Decay, Early Unwind and Closeout Feedback Effects (April 19, 2017). Available at SSRN: https://ssrn.com/abstract=2945989 or http://dx.doi.org/10.2139/ssrn.2945989

Anthony J. Seymour

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, 7701
South Africa

Florence Chikurunhe

Peregrine Securities ( email )

21 Main Road
Claremont
Cape Town, Western Cape 7700
South Africa
+27117227551 (Phone)

HOME PAGE: http://www.peregrine.co.za

Emlyn James Flint (Contact Author)

Peregrine Securities ( email )

15 Cavendish Street
Claremont
Cape Town, Western Cape 7700
South Africa
27117227556 (Phone)

HOME PAGE: http://www.peregrine.co.za

University of Pretoria ( email )

Economic and Management Sciences
Pretoria, Gauteng 0002
South Africa

HOME PAGE: http://www.up.ac.za/mathematics-and-applied-mathematics

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