How A Super-Cheap, Super-Volatile New Options Strategy Has Emerged To Help The Pros Cream The Little Guys

Volatility is increasing for systemic reasons, and that is a big opportunity for long-term investors.

The S&P 500 closed unchanged on Tuesday, yet behind the scenes traders were frantically buying and selling. It’s a new reality driven by zero-day-to-expiry options, a relatively new investment tool.

The mechanics of 0DTE options are a big win for Morgan Stanley (MS).

The defining feature of 0DTE options is that they expire on the same they are issued. This extreme short-term structure offers a big advantage for speculators. Options give the holder the right to buy or sell an asset at a fixed price, by a given date. However, a large portion of the cost of an option is based on the life of the contract, or time value. 0DTE options largely eliminate time value, thereby creating greater leverage.

A well-timed 0DTE option can produce 1x, 2x, and even 3x daily returns. The prospect of huge profits has lured legions small speculators, and all that this implies.

Analysts at Goldman Sachs note that almost half of all of the options traded daily on the S&P 500 index are now small lot, 0DTE contracts, according to a note in the Financial Times. These small investors have been seduced into the premise that collectively they can force losses upon sophisticated institutional investors.

This David versus Goliath theme played out on 2021 as so-called meme stock investors pushed the shares of GameStop (GME) to triple digit gains. During the process, Melvin Capital, a noted short seller, lost $6 billion and was forced to shutter.

Small investors clamoring after 0DTE index options are betting on a repeat. That is doubtful.

Every option trade involves an actual contract. For every contract holder/buyer, there is a corresponding seller/writer. Wall Street’s largest investment banks are on the other side of the 0DTE option frenzy, often as sellers.

To offset risk, the bankers buy or short the S&P 500 index in the opposite direction of the corresponding 0DTE bet. In theory, this is a riskless trade for the bankers. The growing concern, however, is that these trades are becoming extremely large as 0DTE interest grows, exaggerating volatility. In some extreme cases, simple hedging may lead to market moves exceeding 5%.

Reuters reported October 13, 2022 that the bulk of a 5.4% swing in the S&P 500 was the result of this short-term hedging phenomena. That session, like the Tuesday this week, featured a consumer price index report. Shares opened sharply lower on the stronger-than-expected CPI data, only to reverse all of the early losses, and close higher by 2.6%.

The extreme volatility might seem like a big red flag for bankers. It is not.

Unlike the meme stock rally in 2021 that caused so much pain for professional short sellers, hedging S&P 500 contracts is riskless to bankers. The S&P 500 is an index of 500 of the largest companies in the world. Liquidity is extreme, buffered by other financial instruments and tools.

Moreover, option contract trading is a zero-sum-game. For every winner, there is a loser. 0DTE option trades stack the odds way in favor of bankers.

Morgan Stanley is the leading market maker at the Chicago Board Options Exchange, according to a note in 2022.

Executives at the New York-based firm reported in January that fourth-quarter trading profits soared 26% to $3 billion. Sharon Yeshaya, chief financial officer said that trading was a bright spot in a tough macroeconomic environment. She noted that volumes continue to surge.

The rise in popularity of 0DTE options makes sense. For a large portion of smaller, neophyte traders, buying and selling index options that expire that day must feel like the meme stock era revived. This is a fool’s errand, according findings in a MIT report.

Small investors hold no advantage over larger investors, especially market makers.

Longer-term investors should take the other side of this trade. Pocket the winnings. Buy Morgan Stanley.

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