Zeroing in on 0DTE: A Trading Tool to Try or a Trigger to Volmageddon?

You've seen it everywhere by now: 0DTE options.

Yes, "zero days to expiration" options have taken the investing world by storm. Short-dated options have been around for awhile, and have been traded, but their trading volumes have accelerated this year and everyone is suddenly taking notice.

From a practical standpoint, there have been short-dated options available for some time on some exchange-traded funds like the one for the S&P 500 (SPY) . I think at the start of 2022, they made them available every day, instead of just Monday, Wednesday and Friday.

So, literally, each morning a whole slew of new options are available to trade that expire that day. Those, and ones that expire on Fridays get the most traction. I've seen SPY dominate the daily, with Tesla (TSLA) and VIX, the most common weekly options.

Goldman Sachs has estimated that as much as 40% of the daily volume on the stock exchange could be connected to these daily options, which is why Wall Street is noticing. Some such as J.P. Morgan's Marko Kolanovic have called 0DTE options as Volmageddon 2.0 risk. Others have argued they dampen volatility. I have my own theories and do watch them closely these days as I believe they impact markets.

0DTE in Use

There are features of 0DTE that can appeal to anyone. Let's see some:

* They are relatively cheap to trade/highly leveraged. You can buy one SPY call, and pay less than $1 in fees, plus whatever option premium, and control about $40,000 of notional. That appeals to many investors. The low cost and the high leverage.

* They are a means of managing risk in a volatile market. As many question the depth of liquidity (I think true liquidity is weak, it is hidden by algorithms trying to scalp fractions of a cent most of the time, but disappears briefly on any material flow). We also seem to have more and more "defined" events, such as the Fed meeting and the consumer price index. Very discreet events, so why not buy the "cheapest" option possible? Buy one that just covers the event horizon you are worried about. That low cost is important.

Volumes have declined, especially as a percentage of all option volumes, for options expiring in 27-35 days.

That maturity is what is included in VIX calculations. VIX to me is unlikely to be a useful tool. as that isn't where the hedging (or speculation) is occurring.

Now, let's look at the the many use cases for the 0DTEs:

* We already discussed hedging. But why not spend 50 cents to cover an event when a longer dated option with the same strike could cost $5? If you have a discrete event you can reduce your cost, because you aren't paying for a time horizon that is of no interest to your view.

* Covered calls and even naked put sellers can earn a lot more by selling daily options, every day, rather than selling monthly options. Yes, the price for each day is much lower than the monthly, but it is more than 1/30th, so premium collectors can benefit from daily selling. They may also avoid days that make them nervous. Don't sell a call or put over Federal Open Market Committee meeting day, for example.

* Risk control. With low liquidity and high volatility, traders, including large hedge funds are turning to this product.

* Outright speculation and effectively gambling is here, too. If you want to make a small wager, that could pay off big, unlikely, but it could, then this is the vehicle of choice.

Many of the most active options will get about 200,000 trades in a day, but might have an open interest of 20,000. So they are trading vehicles. People buy and sell them all day long. They are another avenue for profits for algorithms (which means, at least in my mind, that they provide the illusion of liquidity).

They Are 'Trading' Vehicles, and Influencers 

What is their impact on the market? That is the million dollar question. I think it varies by day, but there are some common themes to think about.

One is they can be self-reinforcing.

Let me explain: As investors of all stripes pay attention, they may see a large number of call contracts trading and decide to buy the calls or the market. There is a potential for "circularity" here, where action in this market pushes people to trade the regular market, driving things in the same direction. If there are "delta" hedgers, or people who either by choice (an actual option market maker who wants to trade the option versus the underlying stock) or someone who was naked and gets scared and forced to cover (either the option or underlying stock) you create a self-reinforcing cycle.

This cycle can work in either direction. I suspect that it will get nastier on a down day than on an up day (there is always a seller, but not always a buyer). But I think it will take a lot to trigger this sort of event, so something to watch, but probably at best a monthly or quarterly event.

They can also be volatility dampening. Some say that like option expirations, these will be volatility dampening. The argument is that they will help revert any large moves, that there will be a tendency for things like SPY to settle at the price point that causes the most options or option premium to be worthless (theories that used to be most talked about around "witching" days and OpEx (option expiration) may now come into play on a daily basis.

How I'm Incorporating 'Zero's Into My Routine 

I believe they tend to exaggerate the early move. That, instead of moving 0.5% on some news, we move 1.5%, or something along those lines. So I don't react to large moves, for either stops or adding as quickly.

In terms of "whether to fade a move or not," I first think about if the move seems too large. That makes me think 0DTE might have had an effect. Then I look to what is active after that move/news. If the move was higher and call options are dominating flows, I would not fade the move. If a mix of puts and calls is trading, I'd keep an eye out, and if puts dominated I'm tempted to expect a reversal (the opposite is true on down moves).

Then over the course of the day I look for outlying activity. Without a preponderance of flows, I don't really change much.

If I see calls build on up days or puts on down days I'd start to bet on a "trigger" sort of day where the move we've already seen accelerates.

It is not an exact science and I think it is just one part of market structure, a part that many still choose to ignore, but I think ignoring it can only hurt performance right now.

It is neither inherently good or evil. It is just another tool that affects markets, is interconnected and can cause reactions that we are better off trying to understand than ignoring.

I don't think we can have a large move day, either direction, without a lot of other factors at work (positioning, news, etc.) but the existence and popularity makes the risk of that sort of day higher, and hopefully we can take advantage of it, rather than being caught on the wrong side.