The Games Haven’t Changed, The Casino Opened More Tables

I’m not immune.  There have been copious articles and commentaries about so-called zero-dated options (0DTE) and their pernicious effect on equity markets.  I’ve offered my share, and with apologies, I’m about to offer another.  Anytime something reaches the investment zeitgeist to the degree that 0DTE has, I feel compelled to do my best to explain it.  And when it comes to options, where I spent over two decades as a market-maker and specialist, I’d like to think that I have some insight. 

For those who are concerned that the options exchanges have unleashed some sort of new, untested product into the wild, Jurassic Park-style, let me state unequivocally that this is not the case.  We’ve always had options with short-terms until expiration, just not this many.  A year ago, when the Cboe announced their intention to list daily S&P 500 Index (SPX) options expiries, they noted that: “options expiring within five days or less now comprise 46 percent of total U.S. options volume.”  The exchanges didn’t create a new game – they simply added more tables to the existing casinos.

For the uninitiated, 0DTE options are those with expirations 0-1 days in the future.  It is important to remember that at some point ALL options become 0DTE.  That’s not new, it’s always been the case.  Options expire on a fixed date and time marches on.  I saw a particularly misinformed commentary yesterday showing a table with the some of the day’s most active options – all of which were tech stock call options expiring tomorrow – and tutting about the effect of 0DTE.  The rush into tech calls was notable, but these were regular monthly options that happen to expire on tomorrow’s normal monthly expiration.  With or without daily, or even weekly, expirations, these options would have been among the most actives anyway.

We have long asserted that every new financial innovation gets its real-world test.  Sometimes that test can be extraordinarily painful and expensive.  Think about credit default swaps and their role in the 2008 global financial crisis.  I stand by that assertion, but I also want to stress that 0DTE options are not a new financial innovation.  They are the same sort of options that have existed for years.  Over time we have gone from quarterly to monthly to weekly expirations.  Each brought increases in volume as traders and hedgers had more opportunities to tailor their strategies to specific timeframes.  And for those who hadn’t noticed, we’ve had sub-weekly expirations for years.  The Cboe listed Wednesday-expiring SPX options in February 2016 and Monday expiries in August of that year without much hue and cry.  The exchange added Tuesday and Thursday expirations in April and May of last year, similarly with little concern or fanfare.

Because 0DTE options exist within a well-established risk management and clearing framework, it is hard to see them creating systemic risk, “Volmaggedon”-style.  By definition, the vast majority of these options will not be held overnight.  For better or worse, the options positions will disappear.  Some will be exercised into long or short ETF positions, which does introduce risk for writers, though.  The clearinghouse will typically exercise all expiring options that close $0.01 in the money.  But those who are long options can offer contrary instructions that allow them to exercise or lapse options – a useful feature if markets move after the close.  That could mean that options writers could find themselves with unexpected long or short positions.  None of this is new, and the popularity of cash-settled index options – e.g. SPX vs. SPY – means that many traders have realized that cash-settled options obviate that risk.  Only money, not shares, change hands when cash-settled options expire. (We explain the distinctions at length in this linked article.)

At the root of the 0DTE matter is something far more prosaic.  We’ve created a new vehicle to facilitate speculation.  No one though much about 0DTE options when markets were selling off in December.  The options were available, but they had little overt impact on the declines that were driven largely by tax-loss selling.  Nor did they seem to play much of a role in the early days of January, when the “January Effect” began to lift December’s beaten-down names.  It was only when January’s uptrend became well-established, morphing into a momentum-driven bout of broad-based speculation, did 0DTE options take the fore.

It is clear that 0DTE options are catnip to speculators, many of whom have a mentality more akin to gamblers than investors.  We have previously noted the similarities between betting and options speculation, writing:

In both cases, the options buyer/gambler takes a defined monetary risk in the hope of getting a leveraged return.  There are several advantages to options trading over gambling.  The spreads are tighter, commissions are lower, there is far more activity, and it is much easier to exit a trade.

The confluence of Covid-era lockdowns, stimulus checks, and the expansion of legalized sports betting combined to make options speculation more popular than ever during 2020-21.  Options volumes grew roughly 50% per year in that period, before slowing to single digits last year. 

That the growth coincided with a raging bull market was not a coincidence.  Less experienced traders differ from professionals in a key manner.  Since we’ve mentioned sports gambling, let’s use a sports analogy: Mediocre basketball players are far less able to shoot layups with their non-dominant hand; pros have put in the time and effort to practice going to the hoop with either hand.  Options and stock speculators greatly prefer to trade from the long side, which leads them to chase momentum; professional traders can trade from either the long or short side.

Yet we can only stretch the gambling analogy so far.  Options speculators can indeed influence the outcome of the game!

In a legitimate casino or a fair sports match the outcome is unaffected by the actions of those gambling upon them.  If everyone bets on black, it should have no relevance to whether a roulette wheel spins red, black, or green.  We have seen plenty of football games where an underdog with very short odds ends up winning.  But if a sufficient number of speculators chase calls in SPY or SPX, that can indeed push the underlying index up to and through the relevant strikes.  Whoever is selling the options needs to hedge, and if enough options are bought, the hedging activity can move the underlying higher.  Pressing a winning bet could indeed make it more likely to pay off.

Bottom line, I think it is unproductive to waste too much time handwringing over 0DTE options.  It is quite clear that they facilitate speculation, but they are a tool, not the problem itself.  We’re in yet another bout of furious speculation, with high-beta stocks leading the way.  These options could be causing the markets to act more exuberant than they might do otherwise, but markets typically overshoot.  Focus on the players, not the game.