It's A Race To The Bottom For Wall Street To Figure Out How To Handle The Boom In Zero-Day Options

It's a well-known story. Quantitative easing, leveraged ETFs, and high-frequency trading are three new forces that enter the market, and they give rise to a cottage industry on Wall Street that is devoted to exposing the hazards it allegedly creates for investors.

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A new kind of high-octane stock options called zero-day-to-expiration, or 0DTE, which enables investors to buy and sell with contracts that have a shelf life of less than 24 hours, is now causing it to happen once more. Everyone has entered the debate over how much of a threat these quick-trigger weapons are, from amateur investigators on Reddit to highly paid Wall Street technicians.

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Should the contracts blow up, Marko Kolanovic, a strategist at JPMorgan Chase & Co., cautions that "Volmageddon 2.0" may be on the horizon. Due to the growing influence of options, there is a Twitter account outside of Wall Street that only posts daily forecasts of where the whole equity market will go. One fund manager said that when teenagers began inquiring about them, he became concerned.

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The huge volume of the options market, the brief lifespans of these deals, and the lack of clarity regarding who exactly is utilizing them make it difficult to grasp what the mania might entail. While some believe that derivatives have reduced market volatility, others believe that they have instead caused "an untradable tangle" in the market.

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According to Malcolm Polley, president and chief investment officer of Stewart Capital Advisors LLC, "you always get folks who say, you know, you had to watch out because you're going to create a tremendous problem" when there are significant disturbances like that. "As we've never truly experienced this occurrence before, I don't think people really comprehend,"

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Once companies like Cboe Global Markets Inc. last year expanded S&P 500 options expirations to cover each weekday, zero-day options, which were first discovered by individual investors as a cheap means of gambling during the meme-stock era in 2021, received a new boost on index trading. The Federal Reserve's most aggressive monetary tightening in decades caused daily reversals to rule the market, which led to the offers being an instant hit with institutions. 

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According to data gathered by Goldman Sachs Group Inc., 0DTE contracts represented more over 40% of the total volume of S&P 500 options by the third quarter of 2022, nearly tripling from the previous quarter.

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According to JPMorgan, high-frequency traders, the computer-driven companies present at almost every node of the modern equity landscape, are likely responsible for the sharp increase as market makers and quick-moving investors looking for an edge. 

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Zero-day options contain clear merits as instruments to balance exposure and otherwise fine-tune tactics aimed to reap transitory profits by darting in and out of positions. For firms known to measure the life cycle of trades in thousandths of a second, this is a match made in quantitative heaven.

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Kolanovic, a top-ranked derivatives strategist at JPMorgan, believes that success itself is a recipe for problems. According to him, market makers, who take the other side of deals and must buy and sell equities to maintain a market-neutral posture, are the main source of risk. A self-reinforcing downward spiral caused by the fear is roiling the market as a whole, posing an event risk akin to the volatility implosion of last year. 

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Nevertheless, experts at Bank of America Corp. have swiftly refuted the hypothesis, claiming that the market today is much more balanced than it was five years ago, when everyone was betting on a reduction in volatility that would leave the market open to a sharp reversal.

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Fast-money trend followers prospered shortly after 0DTE volume increased last year, according to a new note from BofA strategists Riddhi Prasad and Nitin Saksena, suggesting that traders were net buyers of such futures at the time. Then, hypothetically, market makers would be forced to follow the current trend by purchasing stocks when they rise and selling them when they fall.

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However, in recent months, intraday momentum strategy performance has steadied, a situation that the team blamed on a rise in option selling. In other words, the market is not the unilateral monolith that would create the conditions for an event like the February 2018 crash.

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The initial demand impulse has probably been absorbed by the 0DTE space, but it has also attracted more sellers, according to BofA strategists. 

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The enormous growth of 0DTE options, according to SpotGamma CEO Brent Kochuba, has actually had a favorable market impact. Using a metric called delta—the potential value of stock needed for market makers to cover the directional exposure resulting from options transactions—he performed research on the effects of the activity. Positive 0DTE delta was associated with market rallies from the beginning of 2022 to mid-February of this year, indicating that short-dated calls were primarily employed to make bets on stock recoveries.

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"0DTE does not appear to be related to betting on a significant downward trend. "High, longer dated S&P volume appears to be driving the big downward market volatility," Kochuba added. "It appears that 0DTE calls are being used to 'buy the dips' following significant falls, which is where 0DTE is now having the greatest of an impact. This somewhat mutes volatility

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In any event, there seems to be a growing interest among day traders in this profitable new game. Under the handle @rt gamma, a Twitter user began publishing analysis on allegedly "real time SPX 0DTE gamma values" in January. Around 2,000 people follow it. 

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When some friends' teenagers inquired about 0DTE choices, George Patterson, the chief investment officer at PGIM Quantitative Solutions, got a whiff of that retail itch recently. He considers such items to be too dangerous for novices, despite the fact that they might be used as a short-term hedging strategy.

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For individual investors, who see 0DTE options trading as lottery tickets, they are just another fad, according to Patterson.

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It is less controversial to say that the rise of 0DTE options is adding to the complexity of the market, where volatility is the only constant. They have recently made it impossible to determine the market's consensus view of the economy, especially on days when important data, like inflation, are released.

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Also, according to some analysts, 0DTEs are undermining the VIX, also known as the Cboe Volatility Index, which is a commonly used fear measure on Wall Street. While the market's increased worry is reflected in those fast-twitch contracts, the VIX, which is derived only from S&P 500 options expiring 23 to 37 days in the future, does not account for any of it.

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Peter Tchir was inspired by the chaos to write "A Day in the Life of a 0DTE Option," a tale that follows the exciting but abrupt journey of a call contract linked to SPDR S&P 500 ETF Trust with a $401 strike price. The head of macro strategy at Academy Securities, who compares trading in zero-day options to wagering on a "horse race," even chose "Sweet Dreams" by the Eurythmics as the theme tune.