Big traders flock to US equity options with fleeting lifespans
Professional traders are plunging into options bets on daily moves in US equities, activity that some experts believe has contributed to recent wild swings in stock markets.
Record numbers of so-called zero-day options that track the S&P 500 stock index are changing hands — with volumes of about 1.5mn a day in November — more than double the levels in January and almost four times those at the start of 2020, according to OptionMetrics.
Options provide the right to buy or sell assets at a fixed price by a given date. Zero-day options provide this right for the shortest possible period, expiring the same day they are purchased.
While options trading has risen broadly since the start of the coronavirus pandemic, Goldman Sachs strategist Rocky Fishman said ultra-short-dated options have been “the strongest area of volume growth”. He estimated that roughly 44 per cent of S&P 500 index options that have been traded in the third and fourth quarter of this year had less than one day to expiry.
The vast majority of the volumes appear to be flowing from professional traders such as asset managers, hedge funds and banks and not retail investors, research shows.
“If I have monthly options, I get 12 independent bets per year. If I have weekly I get 52 bets per year. Daily gives me 252. If you’re generating trading strategies, the ability to have more ‘at bats’ and more diversification by taking more independent trades can be useful,” said Roni Israelov, chief investment officer at wealth management firm NDVR and a former manager of options strategies at AQR.
Buying a zero-day option is a way to gain exposure to intraday price moves with a potential payout in cash. Options sellers collect a premium to bear price risks for a relatively short period. While traders tracking equities indices may also purchase exchange traded funds, which are baskets that hold individual stocks, or own company shares themselves, options are cheaper to buy and the positions do not need unwinding after the contracts expire.
The contracts have been appealing in recent bouts of market volatility, allowing funds to focus trades on specific events such as monthly inflation data releases or days when the Federal Reserve concludes its monetary policy meetings.
“Trying to predict where we’ll be in six months is a daunting task because [at the moment] every day feels like five days in itself,” said Brian Bost, the head of equity derivatives trading at Barclays. “Because the Fed is data-driven, it’s creating more front-loading of expression of views, because people are trying to navigate the next week or next couple of days.”
Some have pointed to the surge in options trading as one propellant of the wild intraday market swings registered this year. Market makers that sell options contracts will hedge their positions to avoid making a bet on the market’s direction.
That hedging can, at times, accelerate broader shifts. If market makers sold a large number of call options that would pay out if the S&P 500 were to rise, for example, they could hedge their position by purchasing S&P 500 futures. Some believe that index futures trading can in turn affect the prices of underlying stocks.
“As options activity goes up, this can create bigger swings,” said Garrett DeSimone, head of quantitative research at OptionMetrics. He said a flurry of recent studies had led to widespread acceptance of the theory that option sellers’ so-called gamma exposure could increase volatility, but said “the point of contention is working out what is its influence at any given moment”.
Nomura analyst Charlie McElligott posited that some financial institutions had been behaving like “full-tilt day traders”, trying to “weaponise” the phenomenon to “amplify and ‘juice’ the intended directional market move”.
Traders used a similar tactic to create short squeezes and drive up the price of individual “meme stocks” last year, but DeSimone at OptionMetrics believed “it would be much harder to do that at a sustainable level on an index just because of the size [of the market]”.
Strategists across Wall Street have been watching the rise of zero-day options for months, at first thinking it was driven by small day traders through online brokerage accounts. But research from JPMorgan Chase indicated that retail accounts were not the principal factor behind the surge, as they accounted for just 5.6 per cent of trading in S&P 500 index options that expire on the same day they are purchased.
The name “zero-day options” can be confusing, as the actual derivatives being traded are weekly contracts that are bought or sold on the day that they expire.
Exchange operator Cboe Global Markets, in attempting to capitalise on the boom in options trading, has spurred momentum in zero-day options by offering new products this year. These include weekly options on the S&P 500 index that expire on Tuesdays and Thursdays that complement products that expire on Mondays, Wednesdays and Fridays.
This means investors can trade large sums of options that mature each day of the week — including as zero-day options when they are on the cusp of expiry.
Amy Wu Silverman, a strategist at RBC Capital Markets, said the shift to use options — including ones that expire on the same day — was in part due to the fact many investors lacked real conviction in the market’s direction and have reduced leverage. But fearful of missing out on an unexpected rebound, traders have turned to the weekly options given their relatively “cheap” cost.