You’re My Hero, Zero[DTE] Options

Will McBride and Dmitry Pargaminik, cofounders of Market Chameleon join IBKR’s Jeff Praissman to discuss Zero Days To Expiration Options.

Contact Information:

https://marketchameleon.com/

support@marketchameleon.com

Note: Any performance figures mentioned in this podcast are as of the date of recording (July 10, 2023).

Summary – IBKR Podcasts Ep. 94

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi everyone, welcome to IBKR podcasts. I’m your host, Jeff Praissman, and it’s my pleasure to welcome back the Co-founders of Market Chameleon— Will McBride and Dimitri Pargaminik.  Hey, guys, how are you?

Dmitry Pargaminik

Hey Jeff, thanks for having us on.

Will McBride

Yeah, Jeff, thanks as always— always a pleasure!

Jeff Praissman

Great to have you guys back in the studio today. And you guys have a long history with Interactive Brokers and are frequent contributors to our platform with research articles, podcasts, and webinars. We actually just wrapped up a great webinar with both of you on 0DTE (zero days to expiration options), but I’ll include links to that webinar for our listeners if they’re interested in viewing the webinar as well. Let’s kind of start off with the first basic question: How long have zero days to expiration options been around?

Dmitry Pargaminik

It’s an interesting question because 0DTE’s, in essence, always existed because when you have an expiration, even a month away, at some point that option will become 0DTE; it will only have one day to expiration. But what happened was that the exchanges noticed that a lot of the trading was concentrated on always the shorter dated options, then they listed the weekly options — Cboe listed the weekly options and so did the other exchanges. They became popular and as they got closer and closer to expiration, the volumes kept increasing. So, now we do have 0DTE options available, but for very few products— I think it’s the major indices and two of the ETFs that track the major indices. So, so far not too many products have 0DTE’s listed on a daily basis, but every stock eventually will have some 0DTE option.

Jeff Praissman

And that’s interesting though because even though there’s only a few, you know, stocks or ETFs that actually have zero days to expiration options— What is the approximate amount of daily volume that these make up though?

Dmitry Pargaminik

In the stats that do have 0DTE options— in the mid 40% of the volume in that stock is in the 0DTE. So, a big portion of the volume is concentrated on those options that expire the same day. And if you really take that day and then the next day, then you get a much bigger percentage— over 60%. But that is, you know, a significant amount of volume in the 0DTE’s.

Jeff Praissman

So, the 0DTE’s are then extremely popular when and where they’re offered versus the traditional monthly expirations that we, you know, grew up with in the past of the third Friday of every month.

Dmitry Pargaminik

Right, exactly. As the options get closer to expiration, we just see more and more volume. So that’s where the demand is. The shorter the date, the more volume we see picking up.

Jeff Praissman

What is the average trade size for these zero days to expiration options?

Dmitry Pargaminik

They’re pretty much, from what we see, equally distributed. As far as 0DTE goes, comparing them to the other options, we see basically the same distribution— You know, small trades, intermediate trades, large trades. Sometimes it’s a little bit harder to calculate because sometimes you see small trades, but they’re an accumulation from somewhere of a much larger trade. So, you could see five lots, 10 lots really quickly accumulating to a couple 100 contracts. And it looks like it’s all part of one trade, just the way that it trades in a long sequence. There’s participation from all types of traders and the traders that trade 0DTE’s, to us, it doesn’t look like these day trade speculators.  Because we see consistent volume day after day and you see mass speculation, usually, you know, those people lose really quickly and it dies down, right? You’ll have stocks with mass speculation, but it doesn’t stay consistent year over year or day after day. And this looks, to me at least, that people are employing certain strategies that are working for them that they feel is necessary and they’re coming back day after day.

Jeff Praissman

So really anyone from the small retail investor to a large institution is probably taking advantage of the fact that these zero days to expiration options are offered and possibly using them for different reasons.

Dmitry Pargaminik

Exactly, yes.

Jeff Praissman

What are some of the benefits of 0DTE’s, you know, versus the longer dated option?

Dmitry Pargaminik

There are a couple of different benefits that are important to note. When we look at a longer dated option, they have several components to it and one of them is the cost of carry. Whenever you take out an option that has a month to go or longer, well, you’re going to have to carry that option. That means to price that option, there’s a dividend in there. Sometimes you’ll have to forecast that dividend, if you didn’t know it ahead of time. Also, there is a cost to carrying an option: It’s either going to be in financing, if you have a margin account, or an opportunity cost. Because if you’re putting money to work and you’re holding it in there, well, at this point, with interest rates at 5%, that means whatever capital or cash you don’t have in your account— you’re investing. There’s an opportunity cost. So, in 0DTE’s, the idea is that you’re leaving flat every day. That option doesn’t carry over to the next day, and if you’re flat every day, then you don’t incur that carry cost. So, you take that off the table. In addition to that, when we look at options, there is a gap risk. The markets close at 4:00 o’clock— you know, some stocks close at 4:15. Then they open the next day but, in between, there could be some kind of news, or there could be some kind of event that is unforeseen or unknown that will make the market move. And if you’re carrying that risk, you’re exposed to that risk; you’re exposed to those types of events. With 0DTE’s, the idea is that you’re leaving flat. So, your risks exist during market hours, which you assume— if they’re liquid— you could start getting out of your risk; if some kind of adverse news appears and you’re following it, you could roll out of it or get out of it. So, the benefit is you avoid the cost of carry and that overnight risk of something happening and that you would not be able to hedge your position or get out of your position until the very next day; and you’re holding that position, you know, throughout that period.

Jeff Praissman

On the flip side of that, what are some of the downsides? You know, that move could also help you, right? You either let the option, you know, expire worthless and all of a sudden that news comes out five minutes later, or 10 minutes later and you don’t get to take advantage of the price move. Whereas if you had a longer-term option, that could go either way. What, in your opinion, are some of the downsides of these zero days to, you know, expiration options?

Dmitry Pargaminik

 The downside to the 0DTE options is that you’d have to create a little bit of a different model and look at data that you probably would not need for an option that’s a month away. So, if you’re looking at a 0DTE option, you’re really analyzing intraday moves, intraday stock behavior, and intraday distribution of returns. So, you’re running volatility models that are looking from close to close or open high, low, close and you average it out over a longer period of time. Here, you have a very short period of time, and that involves more management of your positions because they’re very short periods. The traditional option pricing model uses average daily volatility, right? You’re taking long returns and averaging them out over, you know, a longer period of time; you really can’t use that, it’s not practical to use the Black Scholes model for an option that has three hours to go, then two hours to go, then one hour to go. You’re not going to do annualized volatility, so you’re going to create a different model— probably to trade these 0DTE’s. If you’re buying an option or selling an option that has a month to go, you’re only incurring that execution cost from that period to the end. Here, every day you’re flat; there’s no more position. So, there is a bigger cost to execution, right? You’re incurring more costs to do trades consistently in this year of 0DTE’S.

Jeff Praissman

You mentioned that you obviously can’t use the traditional pricing methods for the, you know, 0DTE’S. So, where do you think people are valuing them? Just taking, you know, kind of directional moves and saying: Ok, I believe, you know, this ETF is going to move up or I have this existing— maybe it’s a combination of an existing position and they just want to take a really short downside protection, or you know, upside protection.

Dmitry Pargaminik

Yeah, exactly. These options are for traders that have a very short-term outlook on the market. And, you know, it could be the start of the day to the end of day. It could be, at some point, at noon to the end of the day, but you really have to have a short-term outlook on the market. And you would need data, right?  You would need more information that is focused on intraday. So, for example, you know, one of the things we do is we monitor and store and look at summary data on the stocks— VWAP, the high low volume for each minute throughout the day. So, we could take a look at and analyze what usually happens from this period to this period or you know from 3:00 o’clock to 4:00 o’clock or from 2:00 o’clock to 4:00 o’clock. And in addition to that, you could input more things in your model if there are certain events you know happen throughout the day. For example, an FOMC meeting or maybe there’s a Fed speaker or there’s some kind of economic event. You could look back and see, well, what usually happens around that time period, given those circumstances. So, I think that when we’re looking at 0DTE, there are some advantages because you have a little bit more ‘knowns,’ you know, you know kind of throughout the day certain events that may happen because they’re scheduled. But you do have to do more intraday analysis on these options and that just requires bigger data sets. You know, getting more information than you would if you’re just averaging it out over a longer period of time.

Jeff Praissman

So, you know, by definition the strategy for, you know, these 0DTE’S really sounds like either short term coverage of an existing position or short-term speculation. But looking for a short term move in either direction and kind of making that play for that day or the next couple of days.

Dmitry Pargaminik

Somebody who has a position may just want to hedge a certain risk during that day. If you know an event’s coming up, maybe an interest rate decision, and at that moment you want to hedge off that risk, you look into the markets and hedge that risk either through a put or a strategy. And there are other trade types, trade movements of the stock and they have their own models calculating probabilities and theoretical value. So, like, for example, if you have $100 stock and you think between the last two hours of trading— if you’re analysis says that you think the stock will move up or down $1.50 and the straddle is a $2.00 bid, then if you’re confident in your theoretical values, that could be your $0.50 theoretical edge, because you don’t care if it goes up or down as long it’s $1.50 or less that straddle will be kept. On the flip side, if you think, ‘well, I think that the stock will move up or down $2.00 dollars,’ the $2.00 straddle could be fair value. At that point, maybe your model says, ‘I think there’s a higher probability that the stock will go up than down.’ If you think there’s a 53% probability that the stock will go higher than that call would have a theoretical edge, right? So, you might say, ‘well, I’ll take a shot on the dollar,’ because I think there’s a better chance it will go higher than lower. And at that point, you know, you are limiting your risk. So, if it goes against you, you lose that dollar. But if you think there’s a higher probability that it goes to $2.00— that could be your theoretical edge. So, you’re working on the strengths of your model, right? You’re working on the strengths of your model; you’re always tweaking to come up with a better, more precise model with less error, and that’s what it is— a competition of models.

Jeff Praissman

And you know, we touched on this in the beginning, but they’re just right now, these 0DTE’S are just for ETFS, a few ETFs and a few indices. You had mentioned that you really see them being created for equities at some point down the line. We all know that the trading volume and equity is sort of top-heavy right? Ten, you know 10 or 12,15 issues that seem to take up 70-80% of the volume. On any given day, do you see any kind of timeline when they will create these? For at least the top ten, I’m assuming that they’re not going to make them for all 5000, you know, stocks that have options on them. It would be kind of a lot of work for a little reward, but certainly big guns like Apple and Tesla and so on— seeing they might fit the bill for a need for these.

Dmitry Pargaminik

Right. And it seems like that would be the next step to take the top 10 most actively traded equity options. And listed on there, I think that the exchanges are moving slowly and carefully because one— they don’t want to look like they’re just creating products for gambling because they’re short term. And the thing with short term is that it generates more execution fees, right? And there’s a bigger term in it, but there is a demand for it. And it would make sense to list more 0DTE’s because there is a cross correlation. A lot of these securities get priced based on cross correlation. If this is this, then this must be priced here, and you get more efficient pricing if you could hedge things off, right? So, if you could hedge your Apple and Microsoft and this 0DTE against you know NASDAQ 100 options, you get more liquidity and you get better price discovery, which benefits the market. So, you would think that the top 10 most heavily traded stocks will start getting 0DTE options listed, even just for that benefit.

Jeff Praissman

What else do you see in the future? I mean, do you see eventually like hourly expirations, at least for the big products or what kind of time period can we get to in these?

Dmitry Pargaminik

That’s a difficult thing to say. I don’t think it’s going to go to hourly anytime soon. It doesn’t seem like we would have even the infrastructure to do that right now. So, I don’t think it’s going to be that short term. It will be interesting to see how this goes, because if you do go to hourly, then you’re narrowing it down to maybe, possibly, events. So, yeah, right now, I don’t think that we would go to hourly. The next thing will probably be just to list more 0DTE options for other products and we already have weeklies, right? We already have weeklies for a lot of these stocks, so at least once a week we have a 0DTE, right? We already have that. And since we have 0DTE existing in two products, it seems like the next step would be to list it for Apple, Microsoft— the big ones.

Jeff Praissman

And I just kind of want to wrap it up, you know, this has been a great discussion. Currently Interactive Brokers offers, you know, late night trading on select products and the exchange is kind of has some extended trading hours as well. What happens if the major U.S. exchanges go to like 24/7 trading? Are they going to have— do you think option trading will follow or do you think it will kind of, say ‘you know what, we’re going to stick with the 4:00 o’clock closing or the 4:15 closing for the indices,’ and let that go. Or, you know, maybe anything’s possible in the future.

Dmitry Pargaminik

That is an interesting question because we have this legacy system that is not very flexible for that. So you can’t just put on a switch and go to 24/7. They are close to that in the indexes; I think the CBOE is very close to 24/7 trading on the SPX because they have extended hours already outside the normal hours. And you know what— when we compare the systems, the cryptocurrencies were— it was this unregulated market structure there. And one of the things that we got to see, you know, when you’re unregulated; unfortunately, there are bad players out there or there are responsible players that could take advantage of it. But at the same time, we saw a lot of innovations there because they didn’t have the same restrictions and they went to 24/7 trading. They’re trading now 24/7 and they were very innovative in ways that, you know, how do you own a digital asset? How do you lend out a digital asset that we don’t have right now in our current system? They started creating these perpetual futures and then they started looking at options exchanges. And I think right now, it all kind of stopped because of what happened with the FTX exchange. But there are a lot of innovations there and I think that that would have been, perhaps, an example of what 24/7 trading would look like in the derivatives markets. But at this point, I think that if we move to 24/7 trading, it would take a while to get there. I don’t think it’s going to be this, you know, switch where we could do it very quickly, probably try to do one security at a time. If they do it, it would take a while just because all the systems, all the regulatory, all the rules were under a completely different assumption. And how it would look 24/7 would require a lot of replumbing.

Jeff Praissman

Got it. Now this has been a great conversation. Will and Dimitri, thank you guys so much for coming by. Just a reminder to our listeners to see more educational material for Market Chameleon— go to IBKR.com, click on education in the top right, and go to IBKR campus, and then click on our contributors to look for market communion. Another reminder that all podcasts can be found on our website under the education tab as well or on Spotify, Apple Music, Amazon Music, Podbean, Google Podcasts, and Audible. Thank you for listening, until next time I’m Jeff Praissman with Interactive Brokers.