Wall Street has accepted that derivatives trading will never be the same after the frenzy for fast-twitch stock options took hold. What it next has to absorb: The equity market itself is threatening to go the same way.
Evidence is starting to stack up that the craze for so-called zero-day contracts, known as 0DTE, is altering how underlying assets behave. The idea is that the surge in trading of these tools — essentially side bets — has become so big that it’s affecting the broader market.
Just this week, JPMorgan Chase & Co. argued the push-pull between ultra-short bets and longer-dated options may be damping day-to-day swings in the S&P 500, which has seen moves of below 1% in all but six of the past 32 sessions. But academic research shows the 0DTE dynamic may be more complex and less benign than that suggests.
A new study from the University of Utah has found that 0DTE trading is actually making America’s benchmark gauge more volatile on an intraday basis. In other words, investors are seeing more swings minute to minute, even as the gauge makes little progress from one day to the next.
The paper, titled How Does Zero-Day-to-Expiry Options Trading Affect the Volatility of Underlying Assets?, found that a one standard-deviation increase in the traded volume of 0DTE options led to a jump of almost 14% in the S&P 500’s daily volatility.
The results add a new twist to an intense Wall Street debate over whether uptake of the options has the potential to destabilize the $44 trillion American equity landscape. Analysts such as JPMorgan quant guru Marko Kolanovic warn their popularity risks reprising past disasters such as the 2018 Volmageddon episode, while others see just another example of doomsayers stirring up fear over the latest market evolution.
“I’m leaning in team Volmageddon,” Jonathan Brogaard, who co-authored the paper with Jaehee Han and Peter Young Won, said in an interview. The study was partly aimed to give regulators “some empirical evidence on whether or not this is something that should be on their plate of concern. And given our results, they should be thinking about it,” he said.
Source: “How Does Zero-Day-to-Expiry Options Trading Affect the Volatility of Underlying Assets?” by Jonathan Brogaard, Jaehee Han and Peter Young Won.
How derivatives markets interact with their underlying asset is the subject of extensive academic scrutiny. A pillar of the 2021 meme-stock craze was the belief that large-scale purchases of bullish options for certain shares could be used to trigger actions among market makers that would turn small gains into big ones.
The latest 0DTE rage involves the S&P 500. Thanks to an expansion of expiration days at exchanges such as Cboe Global Markets Inc., transactions in the derivatives ballooned last year, tripling to 23 million a month. Now they make up more than 40% of the total options volume for the benchmark gauge.
At first blush, the University of Utah study seems contrary to the JPMorgan analysis, which suggested 0DTE options have contributed to muted volatility of late. But the bank also said these contracts appeared to make the broad market more susceptible to intraday turnarounds, or in Wall Street’s parlance, mean reversion. That would fit with a pattern of amplified intraday gyrations — with gains or losses often reversing — that lead to subdued moves on a close-to-close basis.
“My interpretation is that what they find is actually consistent with our results,” Brogaard said.
The Utah team examined volatility at five-minute intervals in the S&P 500 for each day in the past decade, looking for evidence that higher volume in 0DTE options lined up with turbulence in the market. They found that when users rushed into zero-day contracts, swings in the underlying index were wider. In fact, these ultra short-dated options explained — and predicted — market volatility better than contracts with longer shelf lives.
The magnitude of the impact was 58% stronger during morning sessions than in afternoons. The researchers hypothesized this was because there tend to be greater opportunities for speculative trading earlier in the day — major economic data are typically released around the market open, for example.
To be sure, options volume tends to spike during market turmoil and forces such as policy moves can trigger price swings too. As a way to control for what’s known as reverse causality and to mute the influence from other factors, the team also used 0DTE activity with a one-week lag as one of its variables. The approach yielded similar results.
Investors of all stripes have flocked to zero-day options seeking a speedy way to either hedge or make money. The mass dash in and out of contracts is at times believed to have spurred intraday equity reversals, causing headaches for anyone seeking to get a clear read on the market’s macro message.
Employing a method known as the variance ratio test, the Utah researchers looked into whether the market was becoming less efficient because of 0DTE options — and found reasons for concern.
“0DTE options may attract short-term traders who are more likely to engage in speculative trading activities and noise trading,” the trio wrote. “Such traders may introduce more noise into the market, leading to less informative prices and lower price efficiency.”
Source: Bank of America
There are plenty of market watchers who take a more benign view of the 0DTE phenomenon. Nitin Saksena, Bank of America Corp.’s derivatives strategist, has published numerous reports in recent months saying that the warning over “Volmageddon 2.0” is overblown.
If zero-day options were as dangerous as feared, he argues, the market would have shown a strong intraday pattern of trend following — where selling begets selling.
In recent years, the S&P 500’s performance in the previous five minutes has shown little relationship to where it’s heading. In fact, it’s almost a coin-toss, meaning the market has an equal chance of rising or falling next. During the 0DTE era, that pattern has stayed the same.
“You would expect that relationship to be out of line or off the chart if the space was really creating problems,” Saksena said in an interview. “There is not an obvious smoking gun here.”
The divergent views on 0DTE remind Brogaard of high frequency trading, another area of controversy that he stepped into during his early research years.
“It is never going be everyone, every study. But you’ll start to get more and more on one side than the other. So this is just part of the process,” he said. “There will be mixed results on this for the next three years.”
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