Sharp Decline in US Stocks: Is it the Fallout of 'Zero-Day' Options?
Hi there, this is the TradingFlow team trying to provide some news and insights on option tradings. On December 20, the U.S. market experienced sudden volatility, particularly around 2 p.m., with the S&P 500 index dropping by 1.5% in just one hour. This abrupt change drew widespread attention, especially considering the lack of any apparent market-moving factors.
In a normal market correction, stocks that have performed well in the past week or month typically lead the decline. However, in contrast, individual stocks within the S&P 500 on this particular day showed a slight positive correlation with the returns from the previous week and month. Simultaneously, there was a significant increase in the trading volume of put options, especially when the index dropped below 4755-4750 points, indicating a willingness in the market to engage in transactions during the holiday period with low liquidity.
Concerning the reason for the market decline, some market participants began to suspect whether the leverage effect associated with zero-day (0DTE) options could lead to a market collapse. So, what exactly are zero-day options?
Zero-day options, or 0DTE, are options with a maturity of only one day. While the concept of "zero-day" options is not entirely new, the Chicago Board Options Exchange (CBOE) introduced weekly options expiring on Mondays, Wednesdays, and Fridays starting in 2016. This introduced the concept of "zero-day" options, with plans to add single-day expiration options for all trading days by 2022, marking the era of zero-day options in the U.S. stock options market.
Why use them? Like other options, zero-day options can be used for speculating on market trends or as hedging instruments. These short-term options have the advantage of being low-priced due to their short expiration period. Therefore, in turbulent markets, these inexpensive short-term options become a cost-effective way to bet on short-term volatility. Additionally, they are not only affordable but also have high leverage, making them attractive to gamblers.
It's noteworthy that for the same contract, the gamma value of zero-day options is 8 to 9 times that of a one-month expiration option. This makes it appear as a potentially quick route to profits for speculators but comes with corresponding risks.
Currently, over 40% of the trading volume in the S&P 500 index comes from zero-day options, primarily held by institutional investors. Recent market volatility suggests that the popularity of zero-day options might pose a risk of a market collapse.
The S&P 500 index is one of the most liquid indices globally, virtually immune to traditional forms of manipulation in both the spot and futures markets. However, the introduction of zero-day options presents new opportunities for the market.
In the market turbulence on December 20, zero-day options triggered significant intraday volatility in low liquidity conditions. The S&P 500 index dropped by 1.5% within an hour, from the intraday high to the closing. Since the selling started around 2:15 p.m., U.S. stock futures continued to sell off, with the selling amount reaching $9 billion by the close.
Typically, the 1:00 p.m. trading period is characterized by the lowest liquidity and is also traders' lunchtime. Simultaneously, market liquidity significantly decreased due to the holiday season, with December's average market depth being nearly 20% lower than November. Therefore, the substantial sell-off in U.S. S&P futures on December 20 was largely attributed to zero-day option trading.
Data shows that after 2 p.m., the Delta values generated from call and put option trading were almost negative, indicating a significant amount of funds were shorting options at that time. For instance, zero-day put options with a strike price of 473 on the SPY index had little trading activity for most of the day. However, between 2:30 and 2:50 p.m., someone bought over 10,000 of these options at less than $1 each. Similar trades occurred in the options market of the S&P 500 index. These options likely exerted a strong negative gamma effect on market makers, as delta hedging resulted in a large number of sell orders, potentially contributing to the significant intraday selling in the stock market.
Valued at $1 each, 10,000 of these options would amount to approximately $1 million. On that day, the SPY's trading price was around $268, making the value of the zero-day put option with a strike price of 473 nearly $5. Two hours later, $1 million turned into $5 million.
The next day, CBOE intervened, and according to their data, market makers had a positive net gamma value for the day. However, this data is general, making it difficult to manipulate. Additionally, CBOE emerged as one of the major beneficiaries of intraday options trading, with its stock price surging by 125% after this event.
This incident once again highlights the potential impact of zero-day options in the market and the instability they may cause in low liquidity environments. For investors, deeper analysis and risk management become crucial in navigating such complexities.
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Disclaimer: This article is for informational purposes only and does not constitute investment advice. Before making any financial investment decisions, please ensure you thoroughly understand all aspects of the information and conduct your own research.