So it's the weekend and seems like the perfect time to touch on one of the most deliberated and discussed subject in option trading - the weekend effect

Any option trader knows that the weekend has some kind of strange effect on implied volatility and there is not one truth

when it comes to how we should treat the weekend in vol pricing... this is mainly b/c of the fact that option pricing uses actual days (i.e., 365.25 if we want to accurate), while in fact there are roughly 250 trading days/year (ex. weekends and holidays)

this mismatch between act days/trading days creates two effects :
1. it requires us to discount non-trading days when pricing volatility ,
2. it creates a discontinuity in price dynamic, which we should account for (weekend gap on Monday)

Let's first understand how the implied vol is discounted...
So it's friday and you want to collect some decay over the weekend (maybe you have a theta bleed that you want to reduce, or you just wanna collect premium).. you ask your dealer to price you a Monday ATM expiry

the dealer quotes you a 9.5 vol on the option.. you say "man the overnight yesterday was 16, why are you quoting it so low?" well the matter of fact the dealer effectively quoted the vol at 16.5...

It is a given fact that the first two days of the 3-day option are priced at 0

volatility (unless you trade bitcoin or weekend market), so our vol will be sqrt((IV^2)/3), which is 9.25 if we use 16vol... but the dealer quoted 9.5, which takes into account a slightly higher vol (we will touch on that later..)

Now you say, that vol is way to low for me to

sell... so I will be smart and ask for a 1-week option, collect the theta and close on Monday (we assume no events on the calendar)... dealer is quoting 14 vol so you sell..
weekend is over and you come on Monday asking the dealer to quote you the 4-day option and the trader

quotes you 16.8 vol... you say "man! market hasn't moved why are you ripping me off???" the dealer says : 1. b/c I can, 2. b/c you didn't really think that you could have a free lunch, your forward vol off 14 (for 1wk option) and 9.5 (3day option) is roughly 16.6, so I'm marking

it slightly higher (need to make money somehow...)
so the first effect of the weekend is the discounting of the weekend and the repricing of the curve on Monday ( we all know it from the VIX Monday ramp)

The 2nd effect of the weekend is the discontinuity of price dynamic..

As we know, a lot can happen in 48hrs (from global disease to a pissed president threatening to fire the central bank chairman), but because markets are closed we cannot really react in realtime to the news flow, which is why a weekend gap is usually priced in

the option market. No one would demand zero premium for even a slim possibility of a limit down/up at the open.
Historically speaking selling "weekend gap premium" was a systematically profitable strategy, but we all know that it doesn't take too much for "systematic short vol"

to blow up...

so here you have it... a quick and basic guide to weekend volatility...

Hope you all have a nice weekend