September 18, 2023
Options can allow investors to mitigate risk at lower cost
Popular in the United States, daily options are spreading to Europe
Stock market operators are seeing their profits grow at a sustained rate
Paradoxically, the hype could end up generating a stock market crash

CHART OF THE WEEK: "Stock market operators' shares rise"

CHART OF THE WEEK: "Stock market operators' shares rise"


The options market is in full swing, in the United States of course, and, since 1st September, in Europe.

In order to understand in simple terms the opportunities available to investors as well as the risks they face, this analysis attempts to go straight to the point. Zero Day to Expiry (0DTE) options were launched in the United States in 2005. They can be linked to individual stocks, indices such as the Dow Jones andNasdaq, or exchange-traded funds (ETFs), but in practice they are mainly traded on the S&P 500 index.0DTE expire at 5.30pm on the day they are issued. They work in the same way as longer-term options.

The contracts give traders the right (or option), but not the obligation, to buy or sell a specified amount of an underlying asset at a specified strike price on a specified date.

Initially relatively weak, demand for 0DTE exploded during the pandemic. Retail investors found an inexpensive way to trade the rise and fall in prices of 'MEME stocks', those shares supported by a community of traders on discussion forums such as Reddit, like GameStop or Tesla. By extension, 0DTE were made on the major US indices and ETFs.

In a second phase, from 2022 onwards, heavyweight institutional traders began to take an interest in the daily options market. They became so keen that their order books now account for 95% of total volumes.Daily trading volume has exceeded one billion dollars, reaching 43% of the volume of all options linked to the S&P 500 index (see Fig. 3).

Fig. 2 - GameStop & Tesla share prices - Fig. 3 - S&P500 options volume by expiry date
Fig. 2 - GameStop & Tesla share prices - Fig. 3 - S&P500 options volume by expiry date

This is one of the reasons why Cboe Global Markets, America's largest options trader, has managed to generate significant profits. The company has just announced double-digit growth in annual net sales for the ninth consecutive quarter.

Since the beginning of September 2023, traders have been able to trade 0DTE in Europe, on the EuroStoxx 50 index. Eurex, the derivatives exchange run by Deutsche Börse, is hoping for the same success as in the United States. In the first three days of trading, it negotiated more than 18,000 contracts on be half of 28 institutional investors. If the take-up continues, the company is likely to offer similar options for other indices, starting with the Dax, the German benchmark. Since Thursday 14 September, the USprovider of thematic funds, Defiance, has been offering an ETF that sells 0DTE options on the Nasdaq 100(QQQY US Equity). If it proves a success, the company plans to launch two other derivatives-based ETFs, one linked to the S&P 500 and the other to the Russell 2000. Defiance is not the only company looking to capitalise on the 0DTE craze. In May, ProShares applied to launch an ETF using this type of contract, but it has not yet been launched. In both Europe and the United States, the development of very short-termoptions will make it easier to satisfy investors' insatiable appetite. Demand for these options should therefore continue to grow strongly.

In practice, 0DTE are used to react quickly and precisely to specific market events. In particular, they are favoured for hedging part of portfolios when major economic and financial data, expected during the day, are likely to influence stock prices. These could include economic figures, monetary policy announcements or earnings reports.

Since 0DTE options expire on the day they are traded, their prices can change very quickly and unpredictably, particularly on days when major economic and financial data are released. As a result, potential gains and losses on the option can be very rapid and significant. However, this should be kept in perspective, as the variation in the price of the underlying asset is much smaller, so the impact on the portfolio as a whole will remain controlled.

Given the characteristics of 0DTE options and their skyrocketing popularity, concerns have been expressed about their impact on the underlying equity market. JP Morgan estimates that a stock market crash similar to that of February 2018 could now be triggered even more easily. At that time, some short-term exchange-traded products, such as XIV, which bet on low market volatility, lost more than 90% of their value overnight (see Fig. 4).

Fig. 4 - Inverse volatility strategy - Fig. 5 - S&P 500 index, 14 to 16 August 2023
Fig. 4 - Inverse volatility strategy - Fig. 5 - S&P 500 index, 14 to 16 August 2023

This summer, volumes on 0DTE were so high that some investors suspect they were behind the flash crash in the US markets at the end of the session on 15 August. For the record, the index lost -0.4% in just 20 minutes, closing the session down -1.2% (see Fig. 4). Goldman Sachs and Nomura, for example, consider that daily options were the cause. During this short period, a wave of put options with strike prices of around $4,440 entered the currency, forcing market makers to hedge their positions by selling equities and futures. The Bank of America, on the other hand, considers that there were just slightly more short positions than long positions that day, and that the net impact on market direction was minimal.From a candid point of view, let's say that the influence of the 0DTE on daily market movements is technically possible because the volumes are huge. As option premiums are small, investors will try to sell large volumes of options to generate enough protection for their portfolio. Since margin calls are technically impossible on a single day, this leverage is a real danger.

Conclusion :

In volatile markets, where the publication of economic and financial data can have a major impact on portfolio performance, daily options (0DTE) offer an innovative solution. They offer investors an appealing alternative for managing short-term risks. Ironically, if 0DTE volumes were to become too high and a vast majority of investors were looking to protect themselves against a stock market flash crash, this fear would become self-fulfilling. The quest for individual safety could end up creating a collective risk.