Lawrence Ullman is the chief executive of Ullman Wealth Management Inc., which provides private capital-management services to high-net-worth individuals, endowments, charities and foundations.
Interest in options trading has soared in the past few years, and it’s beginning to worry some investors. A notable increase in the use of very short-term options, known as “zero-day-to-expiration” contracts, might be driving volatility higher in securities that track major indexes, such as the SPDR S&P 500 ETF (SPY).
Zero-day-to-expiration options, known as 0DTE options for short, are option contracts that are due to expire at the end of the current trading day. Time is of the essence when trading these kinds of short-lifespan options. They may only have hours, or even minutes, to be worth either something or nothing at all.
For the option buyer, an advantage of using these contracts could be in making directional bets for relatively little cost. Also, the ability to hedge a portfolio only on the day of an important economic release has some allure to it.
For the option seller, these contracts may be enticing as well. Option premium decay is very rapid with such little time remaining. The phrase “making a quick buck” comes to mind. The problem is that these trades could very well mean losing a quick buck. But traders have not been deterred: 0DTE trading accounts for more 40 per cent of S&P 500 options traded in 2023, according to the Chicago Board Options Exchange. As of August, this number was closer to 50 per cent.
From a broader market perspective, there is reason to believe that these 0DTE contracts are contributing to volatility. That’s because of something called a “gamma squeeze.” This squeeze comes about as a result of a type of feedback loop that, if persistent enough, could exacerbate a particularly strong directional move up or down in an underlying security. Think of popular meme stock GameStop in 2021, but with the effect being multidirectional.
As an example, if a trader has sold put options and the underlying security goes down through the option’s strike price, the gamma squeeze effect could require the seller to sell more shares to remain hedged against those options contracts. Then, like dominos, as equity prices are pushed further toward lower strike prices, more selling is required to hedge subsequent strike exposures.
Effectively, sellers of options can be forced to chase stocks both up and down in order to maintain the hedge, which creates more volatility in equity markets. This is the “gamma squeeze” – a directional move that can be made worse as the volume of short-term 0DTE options rises, increasing the likelihood of frenzied stock buying into a rising close, or a cascade of stock selling into a weakening market.
There are some market experts who believe the increase in the use of 0DTE options could end up causing a volatility “dislocation,” something akin to what we witnessed in early 2018 when an overcrowding in the short volatility trade led to the CBOE Volatility Index (VIX) doubling in a single day. While we don’t believe that this is highly likely, we also believe that under certain conditions, if the planets align just so, a strong selloff could set in motion the kind of move required to make an event like this a reality.
JP Morgan Chase & Co. analysts noted earlier in the year that these options could turn a 5-per-cent intraday market decline into a 25-per-cent rout. It’s certainly possible that, as selling begets selling, a strong intraday decline could trigger more and more of the downward squeezes we illustrated earlier.
Developments in the options and volatility space can influence portfolios, so it’s important to be aware of them. The 0DTE craze is certainly something for investors to monitor.