On October 12, 1987, a week before Black Monday, the Wall Street Journal warned of the potential for significant market volatility. According to the article: Uses of Portfolio Insurance “Could snowball into a stunning rout for stocks.“Today, we are increasingly concerned that another trading tool like portfolio insurance could set the market up for turmoil.
The quote above and a detailed analysis of Black Monday can be found in a Federal Reserve white paper entitled A Brief History of the Stock Market Crash of 1987..
Despite the growing risk for market turmoil, 0DTE is a word that few investors have heard.
0DTE stands for zero days to Options eExpirations These are put-and-call options on individual stocks and indexes that expire within 24 hours. 0DTE options may at first glance seem like speculative YOLO (you only live once) bets. However, when one realizes how brokers hedge options, they realize the potential of these options to create significant volatility in individual stocks and markets.
Before exploring 0DTE options, it is worth briefly discussing the role of portfolio insurance in Black Monday 1987.
1987 Portfolio Insurance
One of our first reactions to hearing about the recent popularity of the 0DTE trade is to recall Black Monday and the 22.6% crash in the Dow Jones Industrial Average on October 19, 1987. There are several reasons for the turmoil, but the factor that has significantly amplified the decline is portfolio insurance.
At the time, institutional investors were buying portfolio insurance from Wall Street brokers to protect against losses. During market declines, brokers’ computer algorithms will automatically short sell S&P 500 futures contracts. As the market sells off more, the algorithm will sell more contracts.
As the programs are sold, they push the market down, requiring more portfolio insurance-related sales. Selling began to sell, and a correction panic turned into an avalanche.
The following quote is adapted from a Wall Street Journal article recounting the turmoil:
The strategy backfired, perhaps because many organizations were doing more or less the same thing at the same time. They send stock prices into free fall and push individual investors under the bus.
0DTE option
0DTE options are growing in popularity rapidly. As the graph below shows, half of the options volume on S&P 500 futures is 0DTE. This dwarfs the 5-10% share that existed before the pandemic.
Individual and institutional investors are using options that have little time until expiration for speculative and hedging purposes. It is also possible that investors can manipulate the market using 0DTE options. Regardless of purpose, 0DTE options have the same characteristics as portfolio insurance; They can significantly intensify market movements.
To repeat the WSJ quote: “The strategy backfired, perhaps because many organizations were doing more or less the same thing at the same time.” Sound familiar?
How manipulation creates significant volatility
To help better appreciate the risk of 0DTE options, we walk through a hypothetical example using Tesla stock. This case uses data from the early afternoon of January 25, 2023 After the close that day, Tesla reported its quarterly earnings
Hypothetical hedge fund ABC owns 100,000 shares of Tesla stock (TSLA). TSLA was trading at $144, meaning ABC had a $14,400,000 investment in TSLA. With earnings due soon, ABC wanted a low-cost trade so that their earnings were better than expected.
One such way is the 0DTE option. To do this, they can buy calls with a $160 strike that expire within a day. At that time, the price per 0DTE call was $1.36. Each call option controls 100 shares. If they choose, buying 1,000 calls will entitle them to buy 100,000 shares at $160. The option cost was $136,000 or about 1% of their total Tesla investment. If TSLA shares flop on earnings, they will lose 1% in options. If the stock goes up, they will likely sell the options and easily double or triple their returns. More importantly, their calls can buy significantly more if the stock goes up.
Delta hedging begets delta hedging
As often happens, ABC buys calls indirectly from a Wall Street dealer. Most dealers run managed books which means they have limited risk tolerance. Accordingly, they often hedge their risk. In this case, the dealer’s risk is Tesla’s price increase.
Dealers use a hedging method called delta hedging. An option’s delta estimates how much an option’s value can change for a $1 move up or down in the underlying security. Delta was .15 at the time of the trade. For every $1 that TSLA shares rise, the options will increase by 15 cents. Delta increases toward 1.0 as price approaches the strike price and decreases toward zero as price declines.
The dealer can delta-hedge the calls in our scenario by initially buying 15,000 shares (.15*100,000). The number of shares they own will vary according to the delta as the price rises or falls. The table below estimates the delta for Tesla shares on that day for a range of prices.
If the hedge funds are right and Tesla has excellent earnings, the stock will jump and force dealers to buy more Teslas. The higher it goes, the more shares they have to buy. As dealers and other dealers increase their hedges, buying pressure on Tesla shares increases and pushes the delta higher. Buy baguettes.
Alternatives in the market
The Tesla 0DTE example relates to the movement of a stock. While Tesla’s price may be more volatile than it would have been without 0DTE options, the impact on the broader market is limited.
More to the point, investors are buying 0DTE calls and puts on the S&P 500 and other indices. Often such options are purchased in advance of potential market-moving events. Recently, the CPI, Fed meeting, and employment reports have drawn significant interest from 0DTE traders
Suppose 0DTE volume is large enough, and option buyers are betting on the same directional market move. In that case, the market is ripe for significant volatility if dealers are forced to aggressively hedge deltas. Adding strength to such events, investors become irrational when the market declines rapidly. A significant downward move could trigger panic selling by other investors. Selling can beget selling, and a few percent loss can quickly turn into a serious decline.
summary
If you take one thing away from this article, it’s that for every option, there is probably a bank/dealer on the other side of the trade. The risk management protocol forces dealers to buy or sell up to 100 shares of a stock or index for each option. It takes little money for a hedge fund to manipulate stock or index prices and, therefore, little money to create market turmoil.
Unlike portfolio insurance, delta hedging is limited because delta can only go to one or zero. However, a heavy dose of delta hedging can cause panic among other market players. Fear can breed fear!
Closing note
When we calculate the TSLA 0DTE example, Tesla closes the day at 144.43 minutes before the company reports its Q4 earnings. Its shares rose 10% the next day, the most in six months. 0DTE must have helped TSLA shareholders!
Twitter: @michaellebowitz
The author or his firm may have positions in the securities mentioned at the time of publication. Any views expressed herein are solely those of the author, and in no way represent the views or opinions of any other person or entity.
