Breaking Down the Risks of 0DTE Options
By Justin Zacks, Vice President of Strategy, Moomoo Technologies Inc.
Zero days to expiration (0DTE) options.
Just the name alone might sound scary, but if you trade options, there’s a good chance that you may be confronted with them at some point.
But before you dive into trading 0DTE options, it’s important to first understand their risks. 0DTE options exhibit some of the same risks as long-date options, but they can be more difficult to navigate.
What are 0DTE options?
At first glance, 0DTE options may seem fairly straightforward: they’re options that trade and expire on the same day.
Even the most long-date options eventually become 0DTE options when their expiration date rolls around. But in reality, 0DTE options are much more nuanced, with their risk levels determined by how they are used.
There are unique risks to 0DTE options, and that’s why it’s important for investors to educate themselves. Read on to learn more about them and their potential risks.
0DTE options: Reaching new heights with more expiration dates
Today, 0DTE options make up more than 40% of the S&P 500’s total options volume, according to Goldman Sachs(1). Some of this popularity stems from the fact that there are now more expiration dates.
Stock options (also sometimes called equity options) as we know them today, started trading on the Chicago Board Options Exchange (Cboe) in 1973. Until 2005, these options expired on a monthly basis, usually the third Friday of the month. At that time, the exchange added weekly Friday expirations.
Then, Cboe added Monday and Wednesday expirations on the popular index exchange-traded funds (ETFs) in 2016. In 2022, the exchange added Tuesdays and Thursdays for five-day-a-week trading, including 0DTE options.
Why go five days per week?
These developments were driven by investor and trader demand for more choices. Now about $1 trillion in notional amount (the total value of the underlying asset in a contract) trades every day, according to JPMorgan(2). This demand is driven by different types of traders: retail, buy-side (investment managers, pension fund and hedge funds), market makers, and arbitrageurs.
Each unique group of traders have their own reasons and goals for trading 0DTE options, but many are commonly drawn to these factors: a lack of interest rate, early assignment or loss of dividend risk, and the lack of potential margin calls for long options holders.
How do 0DTE options differ from long-date options?
Many traders view options by the number of days to expiration, not by the exact date. This affects risk, among other factors. An option expiring on December 15, for example, will have a much different risk profile and investor demand based on whether it is November 15 (30 days to expiration) or December 15 (zero days to expiration).
To understand the difference, it’s important to delve into how options are priced.
The value of an option is primarily made up of two parts:
Intrinsic value: the difference between the current price of the stock and the option’s strike price
Time value: based on the expected volatility of the stock’s price until the option’s expiration.
A long-date option’s value is dominated by the time value component, as it’s more sensitive to changes in the expected future volatility of the stock. A short-dated option’s (like an 0DTE option) value is dominated by its intrinsic value; it’s much more sensitive to moves in the underlying stock.
What are the risks of trading 0DTE options?
Here are some differences from long-date options that can make trading 0DTE options riskier.
Time value: Let’s say a stock is trading at $101 a share. A $100 strike call would have an intrinsic value of $1. If the stock fell to $99 a share, it would lose all of its intrinsic value and only be left with time value.
If the option’s expiration was far into the future — say one year from now — it would still have a significant amount of time value remaining. But in the case of a 0DTE option, its time value would disappear by the end of the day if the stock remained below $100 a share.
In this scenario, an option initially worth over $1 would expire worthless, and a trader holding such a position until expiration would lose all their money.
Risk of being flagged: There’s a greater chance of being flagged as a pattern day trader (in other words, someone who executes four or more day trades over the course of five business days in a margin account). This could limit accounts with under $25,000 in equity with expiration or pin risk.
Pin risk occurs when a stock closes the day very close to an expiring option’s strike price. In the example above, a case would occur if the stock closed at or very near to $100. In this instance, the owner of the call option has to make a decision whether to exercise that call option and take delivery of the underlying stock or to let it expire worthless.
The trader on the other side of that trade, short the call option, has the pin risk.
This trader will not be informed as to whether she must fulfill her obligation to sell the stock to a long call holder until after the market is closed. This creates a risk where the short call option trader may have a large stock position the next day or not, depending on what the long holder does. This type of situation is difficult for the short trader to hedge due to the uncertainty.
Are there risks to the overall market from 0DTE options?
Some market participants may think so.
Individual risks aside, there exists a debate among strategists as to whether 0DTE options pose a risk to the market overall such as a major one-day crash, seen in 1987.
JP Morgan Chief Global Market Strategist Marko Kolanovic warned of this possibility — which he termed “Volmageddon 2.0” — given the increased use of 0DTE options. The original “Volmageddon” occurred on February 5, 2018(3), when a sudden rise in volatility led to major losses in short volatility exchange-traded products.
And this theoretically could happen again.
If market makers who sell these options to traders panic and scramble to cover their short positions because of a major stock market drop, it could potentially trigger a chain reaction of selling. It’s like a snowball effect: selling leads to more selling.
But in a recent Cboe paper(4), it noted such exacerbated moves in the SPX index are a “valid concern in theory,” but in “practice customer flows tend to be fairly balanced in terms of buys and sells.”
What are some features on moomoo that can help with 0DTE options?
Given the risks involved in trading 0DTE options, it’s important for traders to educate and familiarize themselves with these products.
The moomoo app offers several tools and features to help traders. Paper trading is a great place to start. It offers users the ability to create simulated options portfolios without risking real money.
The app’s options price calculator has many inputs that users can tweak to see how an option’s theoretical value changes. For instance, a user could change the implied volatility input either lower or higher and note how the value of the option reacts. And finally, when users are ready to take the next step, the app’s options implied volatility ranking tool and unusual activity screen can help users flag potential opportunities.
Sources
2. Explainer: The rise of 0DTE stock options and how they could be a risk to markets
3. What Is Volmageddon? Why Record Options Trading Could Risk Another 20% Stock Crash
4. The Risk of SPX and 0DTE Options
Opening new options positions close to or on their expiration date comes with substantial risk of losses for reasons that include potential volatility of the underlying security and limited time to expiration. The strategies that may be covered are not suitable for all investors and should be utilized only by sophisticated investors who understand the essentials of options and the risks of 0DTE options.
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