A potential stock-market catastrophe in the making: The popularity of these risky option bets has Wall Street on edge
Professional and amateur traders are flocking to a risky type of equity option that some have likened to lottery tickets, drawn by the opportunity to reap massive returns in the span of just a few hours.
They’re known as options with zero days until expiration, or “0DTEs.” Named because they have less than 24 hours left in their lifespans, traders see them as a way to place tactical bets around potentially market-moving events like economic data releases and Federal Reserve meetings.
Some on Wall Street are concerned that the growing popularity of 0DTEs is making U.S. markets more volatile and more fragile as outsize daily swings in the largest, most liquid equity indexes, like the S&P 500
become more frequent.
Some are even concerned that they could contribute to a destabilizing blowup with far-reaching consequences for market stability.
Trading volume soars as markets slump
Call options are derivatives that allow users to buy an underlying asset at a certain price by a specific date; put options allow the user to sell at a certain price by a specific date. Options prices can see big swings as they near expiration.
According to data shared with MarketWatch by Cboe Global Markets
average daily trading volume in S&P 500-linked 0DTEs surged in 2022 as U.S. stocks started to slide into a bear market from their record highs reached in January of that year.
During the first quarter of last year, 0DTEs represented just 22.5% of average daily trading volume in S&P 500 options traded on the Cboe. By the end of the fourth quarter, that figure had risen to 44%. Paul Woolman, global head of equity index products at CME, said trading in 0DTEs has continued to climb in early 2023.
CME Group Inc.
and Cboe, which run the two main options exchanges in the U.S., catered to the growing demand by offering options that expire every day of the week for some of the most popular U.S. equity indexes and ETFs. Representatives for both exchanges said they have plans to add daily expirations for more products this year.
Arianne Adams, senior vice president and head of derivatives and global client services at Cboe, said the exchange’s customers have been pushing for more daily expirations because they allow traders to be more “tactical” and “precise.”
‘Picking up pennies in front of a steamroller’
One reason 0DTEs have become so popular is that the trading strategies that worked when interest rates were at or near zero simply don’t anymore. A long-running period that had seen stocks generally move higher came to a halt last year, giving way to more wild swings in both directions. So traders looked for a new way to capitalize.
Ernie Varitimos, a trader who runs a Twitter account dedicated to trading 0DTEs, told MarketWatch that it’s this “asymmetric” risk that drew him to them.
“It’s a trade where I can take very small risk for a very large reward,” he said, in a phone interview.
The problem from a risk-management standpoint is that there are always two sides to a trade. When one trader buys an option, another sells. The risks for the buyer are capped because, at worst, the option would expire worthless, limiting the buyer’s loss to the premium paid.
The risks for unhedged sellers runs much higher. A person who sold a call option would be exposed to theoretically unlimited losses since there’s no limit on how high the price of the underlying asset can rise, while a person who sold a put could also see significant losses if the buyer exercises the option.
This creates serious risk-management problems for market makers and traders who sell the options, given their open-ended risk.
“It’s like picking up pennies in front of a steamroller,” said Charlie McElligott, managing director of cross-asset strategy and global equity derivatives at Nomura, about the risks associated with selling these options. McElligott has written extensively about 0DTEs and their impact on markets.
In a research note published Wednesday, JPMorgan’s Marko Kolanovic, one of the bank’s top equity strategists, warned that the rising popularity of 0DTEs could trigger “Volmageddon 2.0,” a reference to the February 2018 implosion of several esoteric volatility-linked products that spilled over into the broader market.
The Dow Jones Industrial Average
plunged 1,175.21 points, or 4.6%, on Feb. 8, 2018. At that time, it was the biggest daily point drop for the Dow in history.
One problem as Kolanovic, McElligott and others explained it, is that 0DTEs are extremely “convex” — meaning small moves in the S&P 500 can drive huge fluctuations in the value of these options. They can go from worthless to worth thousands of dollars per contract in a matter of minutes. Kolanovic didn’t return a request for comment.
Since they’re so close to the end of their lifespans, risk-management models suggest these options typically have only a small probability of trading “in the money” — trader parlance meaning the underlying asset is above the strike price in the case of a call, or below the strike price in the case of a put.
This makes the exposure very difficult for market makers and traders to hedge.
In his Wednesday note, Kolanovic said the average daily exposure tied to 0DTEs has swelled to more than $1 trillion, but market makers are likely only prepared for some of these bets to pay off on any given day.
Market makers play an important role in helping markets to function. Their business is providing liquidity — in this case, that means taking the opposite side of the trade from customers who are looking to either buy or sell an option. Often, they try to limit any potential losses by hedging some of their risk, buying or selling the underlying stock or stock-index futures.
The fear is that if U.S. stocks experience a particularly sharp and unexpected move, the volume of 0DTE options suddenly trading in the money might overwhelm these hedges, causing a flash crash or a sudden destabilizing surge.
“We haven’t seen the systemic risks present themselves yet, but there’s a concern that if you have a big daily swing, like what we saw during March 2020, that we really don’t know how the market-making mechanism is going to react,” said Garrett DeSimone, head of quantitative research at OptionMetrics, which provides data and analytics about the options market.
Who trades options?
Institutional traders are by far the biggest users of these products. Data from JPMorgan Chase & Co.
shows retail investors account for just 5.6% of overall trading in 0DTEs.
But evidence of the profits and pitfalls of small-time traders buying and shorting — or betting against — 0DTEs is plastered across Wall Street Bets, a Reddit forum where traders go to brag about their profits and commiserate about their losses.
In one post from mid-February, a trader using the handle “Pizza_n_tendies” shared a screenshot from their brokerage account showing they made roughly $6,000 in just over an hour after betting about $3,500 on weekly puts tied to the SPDR S&P 500 ETF,
a popular equity exchange-traded fund.
Back in December, a user with the screen name “livelearnplay” shared a screenshot from a Robinhood account showing they made roughly $100,000 in a single day using 0DTE puts on the SPY , which tracks the S&P 500 index. Others have shared evidence of massive swings in the value of their portfolios as they pursued the strategy over a period of weeks or months.
MarketWatch reached out to both of these accounts, as well as about a dozen others that had shared the results of their trading in 0DTEs. Most never responded. One replied with a simple “hahaha” while another demanded “proof” of credentials before going dark.
‘A game of ping pong’
There are already signs that trading in short-dated options may be leading to more outsize intraday swings in markets, said Brent Kochuba, the founder of options analytics service SpotGamma.
The S&P 500 recorded 122 daily moves of 1% or greater in either direction last year, the most since 2008 and nearly double the 20-year average of 65.6, according to Dow Jones Market Data. This trend has continued in 2023, as the S&P 500 has already seen 15 moves of 1% or more in either direction, the most for the start of a year since 2016.
One memorable example occurred on Oct. 13, when trading in 0DTEs and other near-expiry options helped to trigger a historic intraday turnaround in U.S. stocks.
On that day, the Dow fell just shy of 550 points, or 1.9%, following the release of the September consumer-price index report. Then, on seemingly no news, stocks suddenly rocketed higher. When the dust finally settled, the blue-chip gauge had finished the session up 827.87 points, or 2.8%, at 30,038.72 — a historic intraday swing that Kochuba said was exaggerated by a surge in buying of call options.
“People will sell calls and buy puts at the highs, and then they’ll flip that at the lows,” Kochuba said. “It creates a game of Ping-Pong.”
Exchanges play down risks
Representatives for both Cboe and CME pushed back against claims that these products are making markets more volatile.
“There is nothing conclusive about same-day options trading leading to increased market volatility,” said a Cboe spokesperson in an email to MarketWatch.
But CME’s Woolman said the exchanges aren’t really in a position to comment on the potential risks, since they’re not the ones responsible for managing it.
“It’s harder for us to comment on how this is actually impacting the market because we’re not managing the risk,” Woolman said.
MarketWatch reached out to several options market makers including Optiver, Akuna Capital and Citadel Securities. Optiver declined to comment. Akuna and Citadel didn’t return requests for comment.
During a discussion about the potential consequences of this trend, Nomura’s McElligott told MarketWatch he would be “shocked” if regulators weren’t already trying to gauge the systemic risks tied to these products.
MarketWatch reached out to the Securities and Exchange Commission and Commodity Futures Trading Commission for comment, but didn’t receive a response. A representative for the Federal Reserve’s markets group, another markets regulator, declined to comment.
The big worry surrounding 0DTEs is that they can amplify market swings, potentially triggering a downward, or upward, spiral.
“With daily expirations, each day is it’s own ecosystem. Selloffs can be exacerbated. Rallies can be fed into,” McElligott said. “We don’t really understand where the risk goes.”