In the ever-changing landscape of financial markets, traders and investors continually seek new ways to optimize their strategies. The advent of front-month, daily expirations for some Indices and ETFs have made it possible to execute Zero Days to Expiration (0DTE) options as a tactical alternatives to standard, front-month expiry (or even front-week Friday) options. Although 0DTE options lend themselves to benefiting the more active, higher frequency, market-maker type profiles, this article seeks to shed light on some of the intricacies and characteristics that the product carries.

Zero Days to Expiration (0DTE) option contracts, as the name suggests, are options that expire on the same day they are traded. Traders can utilize these extremely short-durations and not be subject to overnight exposure, a factor that has significantly contributed to their growing popularity.

In comparison to option contracts that have longer (i.e. standard Monthly) lifespans, 0DTE options are even more sensitive to intraday market price and volatility fluctuations and should be actively managed in order to capitalize within the limited windows during which benefits can potentially be found.

“Given how rapidly a 0DTE option’s time value decays over the course of a trading session, it is very much a binary investment instrument. Positions will be closed or exercised for a quick exit before the end of day, or will expire in a matter of hours,” noted Cory Finke, Options Sales Trader at Northern Trust Securities.

Characteristics of Zero Days to Expiration (0DTE) Options

1. Lower Premiums: One of the most appealing aspects of 0DTE options is their lower premiums compared to longer-dated options (given the limited time value that is embedded in 0DTE options).
2. Avoidance of Overnight Risk: Prior to the emergence of daily expirations for certain Indices and ETFs, previously available ‘short-dated’ option contracts might have carried overnight (or multiple days) risk until expiration. This exposed users to overnight price gap risks from potential unexpected headlines or catalysts events. 0DTE options can avoid this risk since they expire on the same day they are traded (if users are not compelled to close out longer-dated expirations early).
3. Capital Efficiency: On a relative basis, purchasers of 0DTE options require less of an initial capital outlay to control the same notional exposure as compared to longer-dated options or outright equity Index futures. This capital efficiency enables traders to engage in a wider range of strategies and manage their exposure more effectively.
4. Quick Profit/Loss Implications: The ultrashort lifespan of 0DTE options allows traders to potentially capitalize on intraday price movements and quickly realize profits (or losses). This quick turnaround aligns well with traders seeking quick, magnified fluctuations in either direction. You really need to remain actively vigilant and engaged with these products from beginning to end.

Popularity and Strategies

The adoption of daily expirations and resulting use of 0DTE options has surged dramatically in recent years, now constituting a significant portion of trading volume for major index option complexes such as the S&P 500 (SPX). According to Chicago Board Options Exchange (CBOE), 0DTE options made up 43% of total S&P 500 Index option volume in the first half of 2023. This is a stark increase from when the CBOE previously reported the duration accounting for less than 17% of SPX option volume back in 2020.

“Based on data we have seen from CBOE, Index and ETF 0DTE options are gaining traction from both Institutional and Retail users. Their data suggests that that Institutions more commonly use SPX 0DTE options, while Retail investors more commonly use SPY ETF equivalents. There’s so much demand in general that it is becoming more common now for market making firms and principal liquidity providers to have dedicated desks exclusively trading front-week duration options”.

Fast, high-frequency traders and active market participants find 0DTE options particularly attractive, due to their ability to swiftly capitalize on intraday price movements. Some popular strategies include:

• Option Writing: Traders often employ simple option writing strategies to benefit from the rapid decay of 0DTE options. These strategies aim for the options to expire worthless by the end of the trading day.
• Iron Butterfly and Iron Condor: These more complex strategies are used to profit from subdued price movements. They involve simultaneously selling both a call and a put option at different strikes while buying further out-of-the-money options for protection.
• Momentum or News-Driven Trading: by using technicals, news events, and momentum trends, traders will seek to profit from purchasing calls or puts to quickly profit with minimal outlay of cash. 0DTE option volume tends to be heaviest on days when news is coming out. For example, 0DTE volumes after FOMC announcements spike dramatically.

Impact on Market Dynamics

The widespread adoption of 0DTE option strategies has had notable impact on intraday market fluctuation, relative to price action and volatility. Even though liquidity within the S&P 500 complex and the avenues that industry professionals can use to hedge 0DTE options (SPX Index and SPY ETF) with are generally very deep, the timeframe people have to hedge or to de risk those option contracts is compressed. These resulting actions, such as buying/selling outright futures or such as covering option exposure entirely can magnify intraday price swings.

“Hedging 0DTE positions as market conditions evolve can create significant price fluctuations, especially in the moments leading up to and right before the market close”, added Finke. “Unsurprisingly, we tend to observe that 0DTE puts dominate volumes on days when the market sells off and that high volumes of 0DTE calls tend to size up when the market rallies”.

Moreover, concerns have arisen about the potential distortion of the broader volatility spectrum, particularly of the widely monitored CBOE Volatility Index (VIX), which measures expected volatility in the S&P 500 over 30 days. The VIX's reliance on the longer-dated 1-month options (compared to the ultrashort variety) makes the Index less sensitive to intraday price movements which are captured by 0DTE options. As a result, some believe that the VIX Index might not accurately reflect a more immediate market sentiment and risk during times of heightened financial or geopolitical uncertainty. To combat this narrative and keep their volatility indices relevant to all market participants, CBOE launched the VIX1D Index (Cboe 1-Day Volatility Index) in April 2023, which seeks to measure the expected volatility of the S&P 500 over the current trading day.

How to Protect Yourself

While 0DTE options do seem to add some intraday volatility, especially towards the end of the day, their market impact has been short lived (just like their maturity). Moreover, these options are not widely viewed to carry a systemic risk. However, large intraday and end of day index shifts have occasionally occurred since the product’s inception and in some instances are believed to have been (in part) the result of the sheer volume of 0DTE contracts changing hands.

It is a risk that some market experts, such as JPMorgan Equity Strategist Marko Kolanovic, are worried about, especially while the VIX Index is relatively low. He suggested a parallel to Volmageddon in 2018, when the S&P market declined more than 3% and the VIX Index doubled in a single day. “While history doesn’t repeat itself, it often rhymes and current selling of 0DTE, daily, and weekly options is having a similar impact on markets. Volumes in these short-term options are very large. If there is a big move when these options get in the money, and sellers cannot support these positions, forced covering would result in very large directional flows”, commented Kolanovic.

In the 3 weeks following the aforementioned Volmageddon, the market clawed back its losses and the event was largely forgotten. This is likely similar to what may happen around a potential future wild intraday swing caused by 0DTE option contracts. Therefore, the impact on investors with long-term investment horizons should be relatively muted. Perhaps some may view such extreme volatility catalysts as opportunities. There is no doubt that trading 0DTEs in such an environment will not come without cost.

While so far at least, extreme concerns associated with 0DTE option implications have largely been unrealized, investors must be vigilant in tracking and understanding how 0DTE options are affecting intraday market moves and volatility. Furthermore, while the increased 0DTE option activity has led some market experts to caution about increased odds for the potential to see catastrophic single day moves, 0DTEs have so far compressed longer-term volatility (VIX) levels, which decreases the cost of traditional hedging. These concepts working together may be reason for investors to begin or increase equity portfolio hedging by seeking customized hedging solutions or increasing allocations to systematic hedging or volatility strategies.

Conclusion

Zero Days to Expiration (0DTE) options have revolutionized short-term trading strategies by offering an array of benefits, including lower premiums, avoidance of overnight risk, capital efficiency, and quick profit/loss realization. The substantial growth in their adoption and volumes underscores their significance in modern financial markets. However, as their popularity continues to rise, traders and investors must remain cognizant of their impact on intraday volatility and their potential to influence the accuracy of volatility projections, such as those measured by the VIX Index. As the financial landscape evolves, striking a balance between innovation and stability remains a key challenge for market participants and regulators alike.