Will Zero-Day Options Spark a Crash in the US Stock Market? Here Are Divided Opinions at BofA and JPMorgan
Since the Federal Reserve began its aggressive tightening cycle in March 2022, the popularity of zero-day options (0DTE options), which are tied to individual stocks and major U.S. stock market indices such as the S&P 500, has grown substantially among high-frequency traders and retail investors alike. According to data compiled by JPMorgan, trading volume for zero-day options has surged to new heights, accounting for 50% of all S&P 500 index options volume - a significant increase from just 5% in 2016.
The popularity of options-based ETF income strategies has surged since the success of JPMorgan's call overwriting fund $JPMorgan Equity Premium Income ETF(JEPI.US)$, which attracted nearly $30 billion in assets under management since its launch three years ago. In response to this trend and the growing demand for 0DTE options, Defiance launched the first 0DTE option-based ETFs -$DEFIANCE NASDAQ 100 ENHANCED OPTIONS INCOME ETF(QQQY.US)$ and $DEFIANCE S&P 500 ENHANCED OPTIONS INCOME ETF(JEPY.US)$ - on September 14th and September 18th of this year respectively. Some are concerned that the entry of ETFs will further intensify risks associated with market volatility.
What are zero-day options?
Zero-day options, also known as 0DTE options, are options contracts that expire on the same day they were traded, rendering them void. As the window is small for traders, any planned moves must be executed quickly. Many traders sell zero-day put options and attempt to capitalize on the final day of trading, with the aim of collecting premium payments. Despite the benefits of low cost and high liquidity for option buyers, it is more akin to a "lotto trade" for a new generation of rookie speculators.
A surge in 0DTE trading has raised concerns about destabilizing financial markets.
The complexity of zero-day options and their "casino-like" nature, particularly their ultra-short puts, have raised concerns regarding their potential impact on market volatility. Some Wall Street analysts are warning that a significant increase in 0DTE trading could potentially cause a market catastrophe comparable to the "Volmageddon" tempest sparked by VIX-linked ETPs in early 2018.
“My concern lies around the complexity of options-based strategies in general. Zero-day options are essentially daily bar bets. While longer-term strategies can certainly be constructed around these options, my fear is that investors might not fully appreciate the complexities and risks involved,” said Nate Geraci, president of The ETF Store.
What happened during the Volmageddon in February 2018？
In February 2018, the $CBOE Volatility S&P 500 Index(.VIX.US)$ experienced a sudden surge triggered by market concerns over the pace of Fed rate hikes, causing significant losses for funds such as XIV, which were designed to track volatility and bet on stock market stability. Although these losses were limited to a small number of funds, their collapse led to further stock market turmoil as banks and investors scrambled to cover their bets. This, in turn, triggered an automatic sell-off of volatility-targeted funds, exacerbating the market downturn. As a result, the $S&P 500 Index(.SPX.US)$ and $Dow Jones Industrial Average(.DJI.US)$ sharply fell by 4.10% and 4.60%, while the $Nasdaq Composite Index(.IXIC.US)$ declined by 3.91%.
JPMorgan's Kolanovic warned that 0DTE will have a similar impact on the market and that "history tends to repeat itself."
Why 0DTE could amplify market volatility
When an investor purchases out-of-the-money calls, the options writer who sold them must continue buying the underlying security to keep a market-neutral position. This buying activity can push up the price of the underlying asset, such as stocks or ETFs. As prices rise, other investors may be encouraged to bet further on the increase, leading to a positive cycle that drives prices even higher.
The reverse is also possible, risks of a downturn in the stock market could be significantly magnified. Goldman Sachs has suggested that bearish orders for zero-day put options have compelled market makers, who are required to manage their exposure, to purchase protective hedges. This has led to a shift away from equities and helped drive the market downward.
JPMorgan strategist Marko Kolanovic warned before that zero-day options could amplify a 5% one-day drop in the S&P 500 to 25% in extreme scenarios.
Some argue that zero-day options are less severe than "Volmageddon 2.0"
Nitin Saksena and Benjamin Bowler, equity derivatives strategists at Bank of America, do not agree that zero-day options will result in a "Volmageddon 2.0". They argue that factors typically associated with market shocks, such as extremely lopsided positions, are currently absent from the market. Additionally, according to their research, holding options on the S&P 500 for one-hour intervals during the intraday session can be profitable for both calls and puts. This incentivizes investors to bet in both directions, rather than favoring one side over the other, which reduces the likelihood of significant market disruptions.
The exchanges have attempted to provide clarification on the impact of zero-day options trading, with Cboe stating that there is inconclusive evidence to support the claim that 0DTE trading has caused increased market volatility.
Source: Investopedia, Financial Times, The Wall Street Journal, OptionMetrics
By Moomoo News Irene
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