Mar 22, 2023
Zero-Day Options Boom Is Turning Wall Street Trading On Its Head
(Bloomberg) -- David Reidy’s sure-fire options trade netted a steady 5% per year for half a decade — until last summer when gains began to peter out all of a sudden.
Reidy, who has been trading S&P 500 derivatives for 10 years, thinks he knows the proximate cause: The new boom on Wall Street in options that have zero days to expiration, known as 0DTE.
“The type of consistent alpha I was generating prior to last year is definitely not available anymore,” said the founder of wealth management firm First Growth Capital LLC in an interview.
His trade was straight forward, selling near-term options to buy contracts maturing days later. But the rush into 0DTE bets has conspired to crush the returns he received on one side of the leg, while the costs on the other stayed the same.
Reidy’s busted trade is just one example of how the rise of trading in derivatives contracts that expire within 24 hours is disrupting the daily motions of the US equity market.
In a month filled with a banking crisis and monetary policy meetings, traders continue to gravitate toward ultra-short-dated options. 0DTE contracts have accounted for 42% of S&P 500’s total options trading volume in March, data compiled by Bank of America Corp. show. That’s up from 22% a year ago.
It’s adding fresh complexity to an equity landscape already rattled by conflicting economic narratives — hot inflation one day, fears for financial stability the next.
While sell-side analysts butt heads over just how risky the boom is, traders are being forced to adapt their playbook fast. To some, the contracts offer new tools to profit in this volatile era. Others see opportunities arising from their potential knock-on effects, like causing market makers to amplify stock moves in either direction.
Meanwhile a clutch of money managers are avoiding them altogether — wary of being caught out by Wall Street’s latest fad.
“They’re not investing vehicles,” said Dennis Davitt, co-manager of the MDP Low Volatility Fund (ticker MDPLX) who started trading derivatives in 1988. “They’re gimmicks. They’re toys.”
By contrast, Matthew Tuttle, chief executive officer at Tuttle Capital Management, began trading 0DTE options for his personal account last year. Now he’s mulling how to incorporate them into the firm’s ETFs.
“A lot of people are gambling with these and some will blow themselves up, but Wall Street will always provide ways for people to pick up pennies in front of a steam roller if they so choose,” Tuttle said. “Whether they pose a risk or not, these are not going anywhere and traders need to account for them and their impact.”
One reason the options look appealing at first blush: Going by face values, 0DTE contracts look inexpensive, typically trading at a tiny fraction of the underlying asset.
The low dollar cost reflects the reality they have less time until expiration and there’s a lower probability they’ll be worth something by expiry.
In the telling of Layla Royer, a senior equity derivatives salesperson at Citadel Securities, the cost to hedge a portfolio has come down significantly as institutions turn to zero-day options.
“You can really isolate events which you couldn’t previously do,” she said. “Institutions continue to lean into that to protect portfolios for low amounts of premium.”
The contracts’ appeal is wide ranging, according to Rob Hocking, Cboe Global Markets Inc.’s global head of product innovation. He said clients are either buying contracts to hedge portfolios or make directional bets, selling as a way to harvest premiums, or buying and selling across multiple legs in complex strategies.
“In a macro-driven tape where company fundamentals may or may not matter on a given day, traditional long/short guys are forced to either get involved in trading the macro or at the very least hedge these major data points,” said Brian Donlin, an equity derivatives strategist at Stifel Nicolaus & Co. “The dailys are cost effective way to do it.”
Nowadays whenever the market lurches one way or another, Danny Kirsch immediately checks on the 0DTE contracts that are outstanding to see if any large transaction is behind the market move.
To the head of options at Piper Sandler & Co., the boom is fostering an intense focus on the here and now — and that may be distorting how the market prices event risk further down the road. One such event is the deadline around the US government debt ceiling in the summer. While Treasury curves have shown heightened levels of anxiety, stock options have yet to reflect the risk, according to Kirsch.
“Events a month out perhaps get overlooked,” he said. That “presents opportunities for investors willing to look beyond 24 hours for perhaps underpriced catalysts.”
Zero-day options first garnered mainstream attention when retail investors embraced them as a cheap way of gambling during the meme-stock era in 2021, but the current craze has been driven by professional traders.
After firms including Cboe last year expanded S&P 500 options expirations to cover each weekday, big institutions instantly latched on in a market where daily reversals were all the rage amid the Federal Reserve’s most aggressive monetary tightening in decades.
Viewed through the lens of implied volatility — or expectations of how much an underlying asset will swing in the future — zero-day options aren’t particularly cheap in reality. The gap over the S&P 500’s realized volatility, something in derivatives parlance known as volatility risk premium, is typically three-times higher than longer-dated contracts, according to BofA.
To make money, one has to be able to get out of the trade in a flash. A JPMorgan Chase & Co. analysis showed that while buying or selling 0DTE options tended to be profitable in the first 10 minutes, two-thirds of the gains came in the first minute.
The returns were completely gone when the contracts were held to expiration. It’s perhaps why, according to JPMorgan strategist Peng Cheng, only around 6% of these options are kept open until maturity.
His arbitrage trade may have been snuffed out by zero-day options, but Reidy of First Growth has quickly learned to adjust. One way he uses 0DTE options is for hedging overnight risk, which may not generate 5% a year, but has other benefits.
“I have not had these nights where I wake up watching futures at three o’clock in the morning,” said Pikesville, Maryland-based Reidy. “It definitely helps me sleep at night.”
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