In trading, the thing that separates the men from the boys (or women from girls, if you will) are the details. The little quirks in pricing models and other analyses and calculations that not everyone knows about. These subtle nuances can cause the naïve to take it on the chin every now and then, while clever traders clean up.
One such quirk centers around the observation of implied volatility towards the end of the trading week. Implied volatility is calculated by taking option values and loading them into a pricing model with all the other relevant data to get the calculated volatility value of current market prices for options.
But what a lot of option traders don’t appreciate is that time decay kind of gums up the works for this calculation. Options lose value by the amount of their theta each day. But theta doesn’t come out of the option price on the closing bell each day. Professional traders have been around the block. They know theta is coming. So they move the day in their models ahead sometime during the trading day (i.e., before the end of the day) to get ahead of the game. In fact, towards the end of the week, they generally start taking time out of their models more aggressively because they need to take out a total of three days of decay to account for the weekend. Often, by the end of the day Friday, they have moved their models ahead three full days to reflect Monday’s theoretical prices.
What does this have to do with implied volatility? Your model that calculates implied volatility does not know that traders have moved their days ahead. It only knows that options have gotten cheaper. Therefore, it yields a calculation of a lower implied option volatility. I would venture to say that traders and investors looking at a calculated implied volatility number (that they have not calculated themselves) dropping on a Friday may be missing something in the eqution: the importance and impact of three days of additional time decay.