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A warning on the growing use of ‘zero day to expiry’ options

Published on 03-30-2023

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Risk of market instability


The numbers speak for themselves. The market for short-term options has proliferated during the past year and is now hitting daily notional volumes of US$1 trillion, according to a recent report from J.P. Morgan Global Markets on February 15. And it isn’t just institutional traders using “zero day to expiry” (0DTE) call and put strategies. In fact, a growing number of retail investors is also trading them, lured by the opportunity to gain big returns in a small window of time.

But here lies a potential problem. As more and more people exercise these types of options to gain exposure to broad-based indexes like the S&P 500, there is an underlying risk that it will create market instability – even more than it may already be doing – and could lead to another so-called “flash crash” in the very worst-case scenario.

In large part, this risk stems mainly from the actions that the seller of a 0DTE may or may not take to protect themselves from significant losses.

For example, let’s first consider the dynamics involved in a call option (versus a put option). On one side of the trade is the buyer or owner of the call, who pays a small premium to have the right to buy an underlying asset at a certain price by a specific time or date – which they will do if the market value of the underlying asset is higher than the agreed-upon price at expiration of the contract. Indeed, that way, they can immediately sell the shares they bought for a profit.

But if the underlying asset doesn’t reach the price agreed upon, the owner can simply let the option expire and their loss is limited to the cost of the option itself, which is usually just a small fraction of what it would cost to buy the stock outright in the first place.

In other words, the buyer’s risk is capped, but that’s not true of the seller. In their case, the potential risk is unlimited because there is theoretically no limit to how high the price of the underlying asset could have climbed at expiry of the option.

And the same goes for put options that allow owners to sell an underlying asset at a certain price and time. While the buyer’s risk is limited, the seller’s is not because there’s virtually no limit to how low the price of the underlying asset could have dropped at expiry unless it falls to zero.

Granted, this isn’t much of an issue to date. 0DTE options rarely get “into the money,” according to J.P. Morgan and generally suppress volatility in the market, not exacerbate it. Moreover, sellers tend to adequately hedge their potential risk by either buying or selling the underlying asset well in advance of the exercise date.

“In-the-money” risk

But that doesn’t mean it can’t become an issue. As J.P. Morgan also recently noted in the same report, one of the worries they have is a big move in market prices that pushes 0DTEs well “into the money,” thus leaving sellers unable to support their positions. In turn, they say this may lead to forced covering that could result in intraday selling or buying worth as much as US$30 billion.

Of course, if that were to happen, market volatility would likely spike – or worse, it could manifest in a severe market meltdown. And while theoretically this could occur regardless of an option’s time horizon, many observers say this is a particular risk associated with 0DTE options (as opposed to more traditional longer-dated options) because even the smallest moves can lead to huge fluctuations in their value.

Ultimately, 0DTEs have become an important trading tool that can often generate positive returns for those who use them. But as they grow more ubiquitous, the level of market risk attached to them continues to grow, too.

John Christofilos is Senior Vice-President, Chief Trading Officer and Investment Management Operations Strategy, at AGF Investments Inc. He is a regular contributor to AGF Perspectives. To learn more about our fundamental capabilities, please click here.

Notes and Disclaimer

© 2023 by AGF Ltd. This article first appeared in AGF Insights and Market Perspectives. Reprinted with permission.

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