Zero-day options: unique market dynamics and risk considerations

In a recent Risk.net webinar, experts discussed the growth and usage of 0DTE options, challenges in modelling their prices and risks, practical risk management issues and whether they pose systemic risks to the market

The panel

• Russel Goyder, Chief analytics officer, Numerix
• Peng Cheng, Managing director and head of big data and AI strategies, JP Morgan
• Amit Deshpande, Head of quantitative investments and research, T.Rowe Price
• Chris Murphy, Co-head of derivatives strategy, Susquehanna International Group
• Moderator: Roni Israelov, President and chief investment officer, NDVR

Impact on market dynamics and trading strategies

0DTE options – options contracts that expire on the same day they are traded – have surged in popularity in recent years, especially for S&P 500 contracts. Interest from retail traders, alongside institutional, proprietary and algorithmic traders, has fuelled growing interest in these ultra-short-dated options, which has had a significant impact on the volatility surface and structure of the market.

Peng Cheng, managing director and head of big data and AI strategies at JP Morgan, observed that liquidity in S&P options has shifted from longer-dated to shorter-dated maturities, including 0DTEs: “There is a ‘liquidity begets liquidity’ phenomenon, which has prompted investors to reassess their maturity choices and engage in shorter-dated trading.”

The experts noted a substitution effect, as some traders transition from longer‑dated options to 0DTEs. Whereas they may have traded one-year or six‑month options in the past, these traders are now trading one-month, one‑week or even one-day options instead. This migration may be driven by factors such as cost efficiency, tighter spreads and the ability to access the short-dated market’s higher liquidity with sophisticated execution algorithms.

Cheng also noted potential substitution effects from S&P 500 E-mini futures contracts to 0DTE options contracts. Because S&P 500 options have a minimum tick size of $0.05, versus $0.25 for the E-minis, some algorithmic trading firms have switched to 0DTE options to benefit from the tight bid-offer spreads, as well as the deep liquidity. Cheng noted, however, that the transaction cost benefits of 0DTE options may be a misperception, as JP Morgan researchers discovered that E-mini futures actually have lower effective transaction costs on a delta-adjusted basis.

Chris Murphy, co-head of derivatives strategy at Susquehanna International Group, has observed a range of intraday strategies, but highlighted a mean reversion pattern, characterised by option buying in the morning to ‘fade’ – or trade against – the initial directional move, followed by selling in the afternoon. “This behaviour can mitigate intraday market moves and may lead retail traders [looking to initially buy the dip or sell the rally] to close options positions early to avoid being exercised into the underlying SPX or SPY positions,” he said.

Institutional use of 0DTE options and implications

While many market pundits suggest that 0DTE options are used to hedge intraday risks, the panellists believed that 0DTEs are not extensively used for hedging purposes by institutional investors. This view was validated by an audience poll where only 6.6% of respondents said they use 0DTE options for hedging. Panellists noted that trading volumes of 0DTEs do not increase significantly during macro events or announcement days, suggesting that discretionary traders may not rely heavily on these options for hedging strategies. Instead, there seems to be a bias towards volatility capturing and directional trades, with a minor net selling bias prevailing in the market.

Concerning risk premia capture, the panel highlighted the popularity of spreads – iron condors and put or call spreads – as popular trading strategies among retail traders. Retail traders often sell spreads to harvest premium while limiting total risk and avoiding large underlying positions. This spread trading behaviour also has implications for market-makers and can contribute to lower intraday volatility. It could also partly explain large 0DTE trading volumes, as the intraday buying and selling of each iron condor requires eight options contracts.

The panel also explored cross-asset considerations and relative value opportunities. They observed that the volatility term structure for S&P 500 options had been relatively steep in recent months, with short-term volatilities lower than long-term ones, and this can affect volatility surfaces across other asset classes.

Amit Deshpande, head of quantitative investments and research at T. Rowe Price, noted that the behaviour of volatility in equities can influence other asset classes, such as high-yield or investment-grade bonds. He also noted that the short end of the volatility surface tended to fluctuate much more than the longer end, as options with 30 days to expiry or longer tended to stay relatively anchored. “These dynamics create tactical relative value opportunities but are dependent on episodic risks and events,” he said.

The discussion also touched on risk management considerations for market‑makers. While gamma risks exist due to directional flows, market-makers have adapted to the consistent volume of 0DTEs and assimilated the associated risks. The prevalence of spreads and the familiarity of market-makers with the flow patterns have aided this process.

Turning to analytics and modelling for 0DTEs, Russel Goyder, chief analytics officer at Numerix, said market participants must go beyond traditional pricing models because of the short time horizons involved. They have to rely on intuition, expert judgement and statistical analysis to navigate these options effectively, and trading can sometimes be more of an art than a science. Option Greeks, implied volatility and other pricing factors can provide a useful framework for understanding and managing risk. “However, more research is needed to develop models specifically tailored to intraday trading and volatility regimes,” said Goyder.

Panellists noted that the Vix index, a popular volatility index introduced more than 30 years ago, remains a useful measure of market volatility despite the concentration of volume in 0DTEs. Goyder said the recently introduced one-day Vix index provides a useful daily indication of expected volatility, but noted that it requires interpretation in the context of the closing print. “It is quite coarse-grained and there are no directly equivalent option instruments that you can map it to, like you can for 30-day Vix, at least until there are intra‑hour expiries.”

Risk management considerations

Touching on the subject of risk management philosophy, Deshpande emphasised the unique characteristics of 0DTEs and the need to go beyond traditional pricing models: “Risk-defined strategies, such as condors or butterflies, are really important as they provide clear boundaries and maximum downsides that are known in advance.” He also recommended setting exposure limits based on total vega or net downside risk, as well as tightly managing positions throughout the day to stay within limits.

The panellists suggested that the economic feasibility of intraday delta hedging for most users may be challenging, because of the high cost of continually paying bid-ask spreads. Cheng noted, however, that electronic market-makers, who benefit from the bid-ask advantage and execute large trading volumes, may have hedging flows that offset each other and may also delta hedge. “Other users such as high-frequency traders will probably not delta hedge, as they are likely using 0DTE options to trade directionally, or as a substitute for E-mini futures,” he said.

Goyder emphasised the need for speed in monitoring intraday risks, recommending real-time monitoring of Greeks, open interest and volumes of out-of-the-money strikes. “It’s important to react quickly to potential crises or sharp market movements, as small intraday moves can escalate rapidly,” he explained.

Potential systemic risks and ‘Volmageddon’ concerns

JP Morgan research has brought attention to the possibility of systemic risks as a result of increased interest and positions in 0DTEs. The panellists discussed the possibility of a ‘Volmageddon 2.0’ and flash crashes, including potential transmission mechanisms.

The analysis suggests that even though the buying and selling volumes in the 0DTE market may seem relatively balanced, there is actually a 2% net selling imbalance. This small imbalance can account for a substantial notional amount, given the large daily trading volumes. “A 2% imbalance on $500 billion notional traded each day results in a $10 billion imbalance,” Peng noted.

He added: “If short volatility sellers were to face an exogenous shock, unwinding their positions could lead to significant market impact due to the magnitude of delta to be unwound.” He suggested that a 1% downward move in the S&P 500, within a very short timeframe, such as five minutes, could lead to an additional 5% downward move, as short volatility sellers tried to exit or hedge their positions at the same time. This scenario could result in a significant decline in the market, similar to the one that occurred during Volmageddon in 2018.

However, Murphy highlighted the difference between the current market dynamics and the original Volmageddon. In the lead-up, there had been several years of one-sided volatility selling, with record low volatilities, alongside leveraged short volatility ETFs containing large positions, which then imploded during Volmageddon. While the current volatility regime is somewhat low, the underlying market dynamics differ from the lead-up to Volmageddon. The nature of 0DTEs, with positions resetting each day, and the mixed dynamics of the market, mitigate the risks, he said. “However, if volatility remains low for an extended period and the selling of these options becomes a more popular strategy, the situation could change.”

The panellists discussed potential spillover effects to other markets and emphasised the presence of negative convexity in the market. They suggested that markets participants should monitor factors such as dealer gamma positioning, the distance and magnitude of dealers’ gamma flip from long to short, and the proximity to significant economic reports or events such as Organization of the Petroleum Exporting Countries meetings, as they could potentially trigger market instability.

Goyder noted that one-day Vix is not a useful metric for identifying volatility regime switches, which are crucial in predicting systemic risks such as these. “Volatility regime shifts are much easier to detect in historical time series data than they are to predict. This remains a challenging area which needs more research but, in the meantime, firms can track total gamma and dealer positioning derived from order flow models, which offer valuable indicators of risk.”

Conclusion

As the prominence of zero-day options has expanded, a diverse range of traders has grown around this trend, with various impacts on market dynamics and trading strategies. The use cases in institutional trading have unique implications for risk management and market dynamics, with many challenges and opportunities associated with analytics and modelling.

The discussion underscored the economic feasibility and trading costs associated with risk management strategies for 0DTE options, emphasising the need for adaptability, real-time monitoring and context-aware decision-making within this fast-paced environment. There are differing views on the potential for systemic risks associated with 0DTE options, but the panellists recommended monitoring total gamma and dealer positioning to assess and manage the risk of market instability.
 

>> Listen to the full panel discussion: Zero-day options: ticking time bombs or high alpha trades?

The panellists were speaking in a personal capacity. The views expressed by the panel do not necessarily reflect or represent the views of their respective institutions.

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