It’s a time-honored tale. A new force enters the market — quantitative easing, leveraged ETFs, high-frequency trading — and a cottage industry on Wall Street is born devoted to exposing the risks it supposedly poses for investors.
Now it’s happening again with a new breed of high-octane stock options known as zero-day-to-expiration, or 0DTE, which allows investors to buy and sell with contracts that have a shelf life of less than 24 hours. Everyone from amateur sleuths on Reddit to highly paid Wall Street technicians have joined the fray, dispensing daily theories about how big a threat these quick-trigger instruments pose.
Marko Kolanovic, a strategist at JPMorgan Chase, warns “Volmageddon 2.0” may be in store should the contracts boil over. Off Wall Street there’s a Twitter account that does nothing but post daily predictions of where the broader equity market will go each day thanks to the rising clout of the options. One fund manager says he got worried when teenage kids started asking about them.
Getting a handle on what the craze may mean is complicated by the enormous volume of the options marketplace, the short lifespans of these trades and uncertainty about just who is using them. While some see the derivatives as reducing market volatility, others see them as a source of extreme turbulence that has contributed to “an untradable mess” in stocks.
“When you get big disruptions like that, you always get people that say, ‘you know, you got to watch out because you’re going to create a big problem,'” said Malcolm Polley, president and chief investment officer at Stewart Capital Advisors. “I don’t think they really fully understand because we’ve never really seen this phenomenon before.”
Discovered by retail investors as a cheap way of gambling during the meme-stock era in 2021, zero-day options got a fresh boost on index trading after firms like Cboe Global Markets last year expanded S&P 500 options expirations to cover each weekday. The offerings became an instant hit among institutions as daily reversals ruled the market, spurred by the Federal Reserve’s most aggressive monetary tightening in decades.
By the third quarter of 2022, 0DTE contracts accounted for more than 40% of the S&P 500’s total options volume, almost doubling from six months earlier, data compiled by Goldman Sachs show.
Behind the explosive rise, according to JPMorgan, are likely high-frequency traders — the computer-driven firms present at virtually every node of the modern equity landscape — as market makers and fast-moving seekers of an investing edge.
It’s a match made in quantitative heaven: For firms known to measure the life cycle of trades in thousandths of a second, zero-day options hold obvious benefits as tools to balance exposure and otherwise hone strategies designed to harvest fleeting profits by darting in and out of positions.
That very success sows the seed for trouble, according to Kolanovic, who is a top-ranked derivatives strategist at JPMorgan. In his view, the risk centers on market makers, who take the other side of trades and must buy and sell stocks to keep a market-neutral stance. The fear is a self-reinforcing downward spiral that rocks the entire market, creating an event risk similar to 2018’s volatility implosion.
But Bank of America strategists have quickly pushed back on the theory, arguing today’s market is much more balanced than five years ago, when everyone was betting on a decline in volatility that left the market vulnerable to a drastic reversal.
In a fresh note this week, BofA strategists including Riddhi Prasad and Nitin Saksena observed that right after 0DTE volume picked up last year, fast-money trend followers thrived, an indication that traders were net buyers of those contracts. Hypothetically, that would leave market makers in a position where they need to go with the prevailing trend, buying stocks when they rise and selling them when they fall.
However, the performance of intraday momentum strategies has stabilized in recent months, a development that the team attributed to an increase in options selling. In other words, the market is not the one-sided monolith that will set the stage for an incident such as the rout in February 2018.
“The 0DTE space has likely absorbed the initial demand impulse but has also drawn in more sellers,” BofA strategists wrote.
To Brent Kochuba, founder of SpotGamma, the explosive rise of 0DTE options has actually acted as a positive market force. He conducted a study on the impact of the activity via a measure known as delta, or the theoretical value of stock required for market makers to hedge the directional exposure resulting from options transactions. From the start of 2022 to mid-February this year, positive 0DTE delta was tied to market rallies, a sign that short-dated calls were mainly being used to place wagers on stock rebounds.
“0DTE does not seem to be associated with betting on a large downside movement. Large downside market volatility appears to be driven by larger, longer dated S&P volume,” Kochuba said. “Where 0DTE is currently most impactful is where it seems 0DTE calls are being used to ‘buy the dips’ after large declines. In a way this suppresses volatility.”
In any case, appetite from day traders for this lucrative new game appears to be on the rise. In January, a Twitter user started posting analysis on purported “real time SPX 0DTE gamma levels,” with the handle @rt_gamma. It has almost 2,000 followers.
George Patterson, chief investment officer at PGIM Quantitative Solutions, got a whiff of that retail urge recently when some friends’ teenage kids asked him questions about 0DTE options. While such products can be deployed as a hedging tool in the short term, he views them as too risky for amateurs.
“0DTE options trades are yet another fad for retail investors, who view these as lottery tickets,” Patterson said.
Less debatable is that the proliferation of 0DTE options is complicating matters in a market where conflicting narratives abound and volatility is the only certainty. They’ve made the task of figuring out the market’s collective thinking on the economy a futile exercise of late, especially on days when key data like inflation are released.
Some analysts also say 0DTEs are muffling the usefulness of Wall Street’s widely followed fear gauge, known as the Cboe Volatility Index or the VIX, as a sentiment indicator. While those fast-twitch contracts reflect heightened anxiety in the marketplace, none of it is captured by the VIX, which is calculated based on only S&P 500 options expiring 23 to 37 days into the future.
All the madness prompted Peter Tchir to pen a story titled “A Day in the Life of a 0DTE Option,’ featuring an adventurous but abrupt journey of a call contract linked to SPDR S&P 500 ETF Trust with a strike price at $401. The head of macro strategy at Academy Securities, who likens zero-day options trading to betting on a “horse race,” even picked a theme song — “Sweet Dreams” by Eurythmics.
“A bit crazy, even by my standards, but felt compelled,” Tchir said.
—With assistance from Isabelle Lee and Sam Potter.