Zero days to expiration (0DTE) options: a strategy for the bold or a voyage into risk?

Zero-day expiration options, also known as 0DTE options, are options that are nearing their expiration date. These options are typically cheaper than similar options with longer expiration dates. The closer an option gets to its expiration date, the faster its value tends to decline. This scenario is akin to supermarket discounting products that are close to their expiry date. Despite this rapid value depreciation, some investors still choose zero-day expiration options.

The appeal of these options is in their capacity for substantial short-term profits, presenting an opportunity to earn significant returns from a comparatively modest investment — the quintessential 'high risk, high reward' scenario.

There have been occasions where the value of these options has surged, multiplying many times over. Nevertheless, treating these options like a gamble and entering without a well-founded strategy can result in considerable losses.

1. 0DTE options: strategy for the bold

In the volatile world of financial markets, trading in zero-day expiration options can be seen as a game for the bold. They offer high leverage due to their low price (as their time value is almost zero), high liquidity, and small bid-ask spreads. This means they can potentially offer high returns and are easier to trade.

Leverage Effect

Understanding the leverage effect of zero-day expiration options requires a grasp of the Greeks: Delta and Gamma. Delta measures how the price of an option is expected to change in relation to a $1 change in the underlying stock. For example, if Apple’s stock price changes by $1 and the Delta of an Apple's option is 0.2, then option price would change by $0.20. Gamma measures the rate of change in Delta with a $1 change in the underlying asset. For example, if Apple's stock changes by $1 and the Gamma of the option is 0.25, then the Delta of the option would change by 0.25.

Options that are at the money and near expiration have a Gamma that can theoretically approach infinity. This means that even minor price movements in the underlying asset can lead to rapid changes in Delta, making the value of the option highly sensitive to price changes in the underlying asset, thereby amplifying the leverage effect.

Excellent Liquidity and Tight Bid-ask Spreads

Zero-day to expiration (0DTE) options are notable for their robust liquidity and competitive bid-ask spreads, characteristics that make them an attractive instrument within the financial markets. These options are sought after by a spectrum of investors, including day traders seeking speculative opportunities, arbitrage traders looking for pricing inefficiencies, and portfolio managers looking for efficient short-term risk management solutions. The convergence of such diverse market participants drives a high volume of trading activity, which in turn bolsters the market's liquidity.

Elevated liquidity levels lead to a dynamic marketplace where buy and sell orders are plentiful. This abundance of market activity typically results in tighter bid-ask spreads, as participants are more inclined to transact at prices that reflect the immediate market valuation to expedite trade execution.

2. Zero-day to expiration options: a voyage into risk

Rapidly Declining Time Value

One of the main characteristics of 0DTE options is that they are close to their expiration date, meaning their time value (the part of the option's price representing the remaining time value) is very low and diminishes quickly. Even slight movements in the opposite direction of the stock price can lead to a rapid decrease in the option's value.

High Sensitivity to Market Fluctuations

Since zero-day expiration options are very close to their expiration date, even minor stock price changes can cause significant fluctuations in the option's value. This high volatility makes predicting the final value of the option more difficult and uncertain.

High Leverage Equals High Risk

Due to their lower purchase cost, zero-day expiration options offer high leverage. This means investors can control a larger asset value with a smaller investment. When amplifying potential profits, it also magnifies potential losses, especially in unfavorable market conditions.

3. How to trade zero-day expiration options

Set Profit and Loss Limits

Due to their significant volatility, the prices of these options can fluctuate wildly in a brief timeframe. Consequently, establishing profit targets to secure gains and setting stop-loss orders to curtail potential losses is essential. When trading zero-day expiration options, the recommended approach is to exit the position once your profit goal is met, resisting the temptation to hold out for more. It's vital to keep a level head, even if the option's price climbs higher after selling. Success in options trading, particularly when capitalizing on volatility, hinges on decisiveness and emotional discipline. Earning profits may be a gradual process, but it's imperative to proactively prevent losses.

Position Control

For options traders, especially those dealing with zero-day expiration options, it is crucial to control their position size. Generally, many investors use options as a tool for hedging risk, so they tend to keep their options positions quite small, for example, around 5%. Investors can decide on their options position size based on their investment goals and habits. Theoretically, whether you're employing a debit spread strategy or going long naked, you should consider whether your overall position is still manageable in the event of a total loss.

Always Be the Buyer

In the world of zero-day expiration options, some investors choose to sell options to earn premiums. However, this approach doesn’t yield high benefits. If the market experiences a significant reverse movement, the losses incurred can far exceed the small premium income. In other words, for a meager profit, investors take on substantial risk.

Conversely, buying zero-day expiration options, while maintaining controlled positions, offers limited loss but greater potential gain. Thus, choosing to buy these options rather than selling them can be seen as a more balanced approach to risk and reward.

At-the-Money First

When trading zero-day expiration options, it's often safer to buy at-the-money (ATM) or slightly out-of-the-money (OTM) options. This is because these options are relatively cheaper, and they have a higher Gamma value.

Gamma is a measure indicating how sensitive an option's Delta is to price changes in the underlying asset. Options that are at-the-money or slightly out-of-the-money tend to have higher Gamma values, meaning their Delta can change quickly even with small movements in the underlying asset's price. Therefore, when you have a long Gamma position, as you do when buying zero-day expiration options, there's a possibility of seeing a significant increase in value if the market moves favorably, though this is not guaranteed.

Pay Attention to Execution

When trading zero-day expiration options, it's important to be aware of liquidity risks on the day of expiration, especially in the latter half of the last trading day, nearing closing time. If you hold zero-day expiration options and don't plan to exercise them, remember to exit before expiration and preferably not wait until the last moment to avoid potential losses due to unexecuted trades. As the closing time approaches, the liquidity of the contracts may decrease, increasing the risk of not being executed.

The world of zero-day expiration options is complex yet fascinating. By buying at-the-money or slightly out-of-the-money options, you may see potential high returns when the market makes a significant favorable move. However, like any thrilling game, zero-day expiration options are fraught with risks, especially regarding liquidity and time value. Therefore, in this practice, timely entry and exit are just as important.

That’s all for today. If you have other ideas about zero-day expiration options, feel free to share and discuss them in the comments section.