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Trading in equity options can be life in the fast lane compared with trading stocks themselves, offering investors big and small a quick road to riches paved with risk. As a form of derivatives, options have traditionally been the domain of Wall Street pros. But retail investors plunged in during the pandemic, and positions began getting opened and closed at a frantic pace. More than 40% of the S&P 500’s trading volume is made up of what’s known as “zero-day-to-expiry” options (0DTE) — a kind of trading that’s once again dominated by institutional investors. To some, recent bouts of volatility show that the zero-day options can wield an outsize influence on the larger equity marketplace, a dynamic known as the tail wagging the dog. Marko Kolanovic, a widely followed strategist at JPMorgan Chase & Co., went as far as warning that the 0DTE mania is putting the market at risk of a serious meltdown.

1. What are 0DTE options?

An option is a contract that gives its owner the right, but not the obligation, to buy or sell a specific amount of an underlying asset at an agreed-upon price, known as the strike price, and on a specific date. A call contract gives the owner the right to buy the asset and a put gives the right to sell it. Both kinds of derivatives are purchased by paying a premium that is generally far less than the cost of the underlying asset. If the asset’s price doesn’t move in a way that makes executing the contract worthwhile, the option expires. Expiry times can vary from days to months. 0DTE options refer to those that have a shelf life of no more than 24 hours. 

Like all other options, 0DTE contracts can be used to bet on market moves or to protect against them, a practice known as hedging, as in “hedging one’s bets.” Investors who want to hold a stock they think will go up could buy puts as a hedge or insurance against a price decline: Being able to sell the stock by exercising a put with a higher strike price would balance out the losses on the stock they hold. Traders convinced that a stock is going to decline can also purchase put options as a direct wager: Once the price falls below the strike, they could buy the stock, sell it at the higher price set in the put, and pocket the difference. Additionally, options themselves can be sold to generate extra income. In that case, the seller gets paid the premium upfront and hopes the contract expires worthless.

3. What’s the advantage of a short-dated option? 

They’re cheaper. Contracts with less time remaining until expiration tend to have a lower value because there is a lower probability that they’d be worth something by expiry. That makes options close to maturity a cheap vehicle to bet on short-term volatility in the underlying asset. In a chaotic market, anything can happen, and these inexpensive short-dated options have become a popular way of trying to make some quick bucks. 

4. When did zero-day options get so big? 

Zero-day options were discovered by retail investors as a convenient way of gambling during what became known as the meme-stock era in 2021. As tech stocks like Tesla Inc. soared, bullish call options gained in popularity as a low-cost way to ride what many saw as a “to the moon” market. Their use then gained traction for trading on stock indexes after Cboe Global Markets Inc. in 2022 added Tuesday and Thursday expiration options for the S&P 500, expanding existing products to cover each weekday. Meanwhile, rival CME Group Inc. also launched e-mini S&P 500 weekly options and broadened them to cover every day of the week. By the third quarter of 2022, such 0DTE contracts accounted for more than 40% of the S&P 500’s total options volume, almost doubling from six months earlier, according to data compiled by Goldman Sachs Group Inc. 

5. How did institutional investors come into the picture?

Professional investors latched on to these fast-trigger, high-risk options trades as the US Federal Reserve pushed through the fastest interest-rate increases in decades in 2022, a move that spurred market volatility. The S&P 500 suffered intraday reversals at a rate not seen since the 2008 global financial crisis. By November, according to a study by JPMorgan, only about 5.6% of all the S&P 500’s short-dated options volume was attributable to retail market orders. Popularity at the scale of what JPMorgan is tracking suggests the new breed of options are being integrated into strategies deployed by the very largest generators of exchange volume. Those include high-frequency traders, the computer-driven firms present at virtually every node of the modern equity landscape as market makers and fast-moving seekers of a trading edge.

6. What’s the attraction of 0DTE options for institutional investors?

It’s a match made in quantitative heaven: For firms known to measure the life cycle of trades in thousandths of a second, 24-hour options hold obvious benefits as tools to balance exposure and otherwise hone strategies designed to harvest fleeting profits by darting in and out of positions. And for fund managers, who mostly cut equity exposure to the bone during 2022’s downturns, buying zero-day call options is one of the easiest ways to play catch-up when stocks rebound.

7. What are the downsides to 0DTE? 

Traders should remember that any strategy that can quickly earn huge profits can probably quickly bring huge losses as well. That’s certainly true of short-dated options, which are very sensitive to changes in the price of their underlying asset. Take Oct. 28, when the S&P 500 jumped more than 2% to close above 3,900. Calls expiring that day with a strike at 3,850 surged to $45.80 from $2.90 — a stunning gain of 1,479%. On the other hand, puts maturing the next session with an exercise price of 3,750 tumbled 97% to 65 cents, after having more than doubling to $24.27 during the previous day. 

8. What has their rise meant for markets?

More volatility, in part because of the way the explosive use of short-dated options has forced a corresponding rise in hedging trades by market makers. The dynamic is complicated, but in the simplest terms, options dealers, who take the other side of transactions, must buy and sell stocks to keep a market-neutral stance. For instance, when you buy a call option, betting that a stock will go up, the options dealer who sold you that contract stands to make money if the price of the underlying stock falls and lose if it rises. So to limit its risk, it will buy some of the stock, and the more the stock rises toward the strike price, the more it will want to buy. The process has at times turned small moves into big ones or induced violent reversals. The proliferation of zero-day options has a warning from Kolanovic, JPMorgan’s top-ranked derivatives strategist, that they might lead to “Volmageddon 2.0,” a repeat of a massive volatility spike in 2018 that roiled markets.

9. What do market observers think? 

Regulators so far have been largely mum on the trading boom in 0DTE options. To Peter Tchir at Academy Securities, a financial advisory firm, the frenzy reflects risk-taking behavior from investors akin to “horse racing.” It’s likely to draw regulatory scrutiny should the activity fuel an equity selloff, he says. More broadly, as 0DTE options add to equity volatility, it makes the task of figuring out the market’s collective thinking on the economy a futile exercise of late, especially on days when key data like inflation are released. They also threaten to make Wall Street’s widely followed fear gauge less effective as a sentiment indicator. While those fast-twitch contracts reflect heightened anxiety in the marketplace, none of it is captured by the Cboe Volatility Index, or VIX, which is calculated based on only S&P 500 options expiring 23 to 37 days into the future. 

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