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How to Trade Zero Day Options

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They’re back! The speculative trading frenzy that dominated the markets’ during 2021, and then went into hibernation during the 2022 bear market has reemerged.

The piling into meme names, FOMOing, YOLOing, bidding up shares of money losing companies, even those bordering on bankruptcy, and squeezing shorts with single day moves in excess of 20% are all there.

And once again its options, especially those with extremely short dated expirations, are the weapon of choice for trying to ride this wave to outsized profits.

The activity has manifested itself in two ways; a surge in call volume vs. puts, makes sense given the incredible start to 2023 which has seen the Nasdaq 100 climb some 15% during the first five weeks. Led by many crowd favorites such as Nvidia (NVDA) and Tesla (TSLA), which have gained over 100% for the year to date.

Second, is the use of short dated options with just one or two days until their expiration date. Last week, nearly $3.5 billion of options with less than 48 hours until traded each day. This represents nearly 70% of total notional option volume.

As you can see Index options, including ETFs such as SPDR 500 (SPY) and Powershares (QQQ), represent the majority of these transactions.

The main culprit for this surge in volume for short-dated derivatives is the advent of “Zero Day ‘Til Expiration” or 0DTE options. SPY, QQQ and futures on the major indices all have option expirations every day of the week.

This chart shows just how extreme this shift has become; nearly 50% of all SPX options traded have less than 24 hours until expiration.

This has several ramifications for both retail traders and institutional investors; not all of which is good or healthy for individual investors.

First, this is clearly no longer a retail/reddit phenomena; institutions have become major players in 0DTE options. Granted the big money is mostly employing an interest rate arbitrage rather than speculative trading. I don’t want to get too deep in the weeds, but it’s basically a very conservative strategy, which typically involves buying a huge amount of deep in-the-money puts against long stock (essentially a flat or delta neutral position) to capture the benefits from the recent rise in interest rates.

But, there is also a fair amount of retail and more aggressive hedge funds using 0DTE, especially out-of-the-money calls, to leverage up and shoot for outsized profits. Some of you reading know Options360, which almost exclusively uses spreads, is not a fan of buying OTM options, or what can be referred to as lotto tickets as most people end up losers over time. That said, it doesn’t mean I don’t make use of 0DTE; I just do as a means of creating calendar spreads in, which I roll the daily options to collect premium and reduce cost basis. 

So, my first concern regarding 0DTE is that retail traders will once again start treating the market like a casino, hoping for fast outsized gains, but will more likely end up with large losses. 

The more worrisome issue is the 0DTE options are causing distortions to daily trading. We’ve discussed how options can sometimes become the ‘tail that wag the dog’ in what is referred to as gamma squeezes. This has led to large intraday price swings with sudden reversals. These sudden liquidity vacuums undermine confidence in the market making it difficult to trust what normally would be reliable set ups. 

Lastly, the large positions in short-dated options might be creating a systemic risk. Should a surprise event come along causing the market to make a large sudden move it could be exacerbated by those who are caught on the wrong side needing to protect their positions creates a feedback loop. 

Unlike stocks which can grow the size of the pie as a company becomes more valuable over time, options are a zero sum game; open interest or the size of the pie can only increase through a transaction of a buyer and seller and then must be closed by expiration. 

Meaning, just like at the casino the beneficiary of the increased adoption of options and short-term derivatives will be the house–namely the brokerage firms and exchanges. 

Brokerage firms benefit from the practice known as payment-for-order flow (PFOF) where market making firms such as Citadel, pay firms such as Robinhood (HOOD) and Schwab (SCHW) to route orders to them. 

Since bid-ask spreads on equity options contracts are typically wider than those on regular stock trades, and the opaque structure of the market, makes executing options contracts particularly profitable. All told options trading represented more than 70% of the $700 million of payments for orders in the last three months of 2022, up from 60% two years earlier, according to BI data. In 2022, Citadel paid approximately $2 billion in PFOF fees. It was clearly with it as Citadel recorded a record $16 billion in profits last year. 

The other big winner has been the exchanges such as the CME (CME), which has exclusives on SPX and NDX futures and options. The exchange reported earnings on Tuesday which blew by estimates thanks to record trading volume. CME shares surged over 8% following the report. 

Several academic studies suggest that retail traders are losing out dearly. One study estimated investors lost more than $2 billion, excluding fees, during the 2021 pandemic boom. It cited bad market timing — and super-wide spreads on their options of choice, among other factors. 

My advice, if you’re going to use short-dated options, do it responsibly. Or better yet, for long term success, expand your time frame beyond the next 24 hours.

To learn more about this options trading strategy, as well as my preferred method of trading options for income, join Options360 today!

I started this service to coach people to becoming more knowledgable and more consistent options traders. Take your trading the next level by join a growing community of like-minded individuals who are committed to learning and growing. Make this year the year your finally turn that options trading corner. Join today…

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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