Since the beginning of 2022, an option-trading strategy that first found favor among retail traders and denizens of Reddit’s “Wall Street Bets” forum has caught on among Wall Street professionals with important consequences for the U.S. stock market.
Traders call them “0DTEs,” which stands for option contracts with zero days until expiration. Typically, they are weekly option contracts with less than 24 hours until they expire. Over the past 18 months, the Cboe and CME have increased the frequency of weekly option expirations tied to the S&P 500
SPX,
and other equity indexes, as well as index-tracking exchange traded funds like the SPDR S&P 500 Trust
SPY,
As a result, traders can trade 0DTEs every day of the week, which has helped to enable the surge in trading of this extremely risky option products.
Trading in 0DTEs comprised roughly 22% of trading volume in S&P 500-linked options trading on Cboe at the start of 2022, but that figure exploded to more than 40% by the beginning of 2023, according to data provided by Cboe.
Risks for dealers are magnified because these options are so extremely “convex,” meaning small moves in the underlying asset or index — often the S&P 500 — can drive large shifts in the value of the option. An option is “in the money” when it can be exercised or sold for a profit.
A 1% swing in the S&P 500 can cause billions of dollars of 0DTEs to suddenly trade “in the money.” Analysts like JPMorgan’s Marko Kolanovic have discussed risks tied to these products, sparking a debate across Wall Street.
See: U.S. stocks set for wild swings as trillions in option contracts set to expire Friday
But there are plenty of other ways trading in 0DTEs is changing the broader stock market. Recently, Morgan Stanley’s quantitative and derivative strategies team illustrated how trading in 0DTEs is impacting the broader market in a research note to clients obtained by MarketWatch.
0DTEs impact how dealers hedge their exposure
Typically, end users of options are net buyers of 0DTEs, according to Morgan Stanley, requiring dealers to carefully hedge their positioning. During at least two-thirds of trading sessions, 0DTE trading flows are powerful enough to flip dealers’ hedging positions, contributing to more seemingly unprompted intraday swings in highly liquid equity indexes like the S&P 500.
They also risk amplifying market swings
Morgan Stanley’s analysis showed that daily returns in the S&P 500 over the prior six months have been about 50% larger when dealers went short gamma intraday, often as a result of trading in 0DTEs. The “gamma” is option market terminology for calculating directional risk exposure changes when the stock price fluctuates.
Forcing dealers to go “short gamma” tends to augment directional swings, the team said.
While potentially fueling ‘uncontrolled violent moves’
The upshot of these prior two findings is that when trading in 0DTEs spikes, stock indexes become more vulnerable to large “uncontrolled” swings if an unexpected piece of news takes the market by surprise.
“…[I]nvestors should be prepared for more realized volatility in the future, and all else equal higher realized volatility makes owning shorter-dated options more attractive,” the team said.
0DTE traders favor risky out-of-the-money bets
Typically, buyers of longer-dated option contracts prefer strike prices that are closer to the market price of the underlying asset, the Morgan Stanley team said. But traders in 0DTEs tend to buy options that would only pay off in the event of a large intraday move.
Cheap up-front costs and a relatively low probability of swinging into the money is why some market experts, including Thomas Thornton, founder of Hedge Fund Telemetry, have described 0DTEs as “lottery tickets” during interviews with MarketWatch.
Often, the most popular 0DTE strikes are as much as 2% above where the S&P 500 is trading, for calls, or 3% below, for puts, the team said.
Retail walked so Wall Street could run
According to the Morgan Stanley team, 0DTE trading was once dominated by retail traders.
But their interest has been relatively flat over the past year, while institutional traders, especially high-frequency systematic funds, appear to have become much more active in trading these products on a daily basis.
“Another datapoint suggesting that some of this volume is systematic is that these high volumes don’t just come on event days — 0DTEs are heavily traded day in and day out,” the team said.
