Understanding 0DTE Part 1: Measuring Volatility

  • Bloomberg – What Are Zero-Day Stock Options? Why Do They Matter?
    An option is a contract that gives its owner the right, but not the obligation, to buy or sell a specific amount of an underlying asset at an agreed-upon price, known as the strike price, and on a specific date. A call contract gives the owner the right to buy the asset and a put gives the right to sell it. Both kinds of derivatives are purchased by paying a premium that is generally far less than the cost of the underlying asset. If the asset’s price doesn’t move in a way that makes executing the contract worthwhile, the option expires. Expiry times can vary from days to months. 0DTE options refer to those that have a shelf life of no more than 24 hours. 
  • Summary

    While intraday volatility rises, longer-term volatility remains subdued. Traditional measures of volatility are being questioned. Understanding how this happened might give a clue as to where the risk lies.

    Measuring Volatility

    The VIX is the most common measure of stock market volatility. The chart below shows the VIX along with the drawdown of the S&P 500. While stocks were down more than 25% from their peak at one point, the VIX remained below levels seen during smaller declines from the past few years.



    Lower VIX readings are typically associated with rising markets and ongoing sanguine trading activity. Despite a relatively subdued VIX, the past couple years have produced wild swings across financial markets. S&P 500 intraday moves greater than 2% have become common, but the VIX remains near a historically low level of around 20. 

    For example, after Jay Powell’s February 12 press conference, the S&P 500 saw moves of at least 1% eighteen times. Five of these reversals were larger than 2%.



    What Changed? 

    Prior to the pandemic, derivatives, specifically options, were most often used by institutions as portfolio hedges and by speculators as a means of making leveraged bets. Since 2020 this has changed. Retail interest in options trading exploded, highlighted by speculation that drove the 2021 meme stock market mania.

    During this same period, weekly options expiring every day of the week were introduced by the CBOE. Volume on these weekly options has exploded. Traders seem especially drawn to the options very close to expiration, known as 0DTE or Zero Days-To-Expiration.

    It has been argued that the drastic rise of 0DTE options might be depressing the 1-month volatility measured by the VIX. In short, the VIX calculation uses options that expire between 23 and 37 days to calculate implied 30-day volatility. 

    0DTE options, or any shorter maturity option, would not be included in the calculation. So 30-day volatility measures do not capture these new and popular options.

    In addition, it is likely that traders who previously utilized options with expirations within the VIX window have migrated to shorter-term options, which could be depressing open interest in the contracts the VIX is calculated off of. 

    It is important to note that risk can not be destroyed, just transformed. While high levels of VIX readings used to indicate volatile periods and mounting losses, a low VIX does not necessarily mean minimal risk in today’s market.


    The Rise of 0DTE

    The next chart takes an even closer examination of this trend. Goldman notes 44% of SPX option volume has been in 0DTE options (black). Approximately two-thirds of options trading expires in less than a week (black and light blue).



    In a different note, BofA also concluded that the rise in the volume on these contracts coincided with the expansion of listed options by the CBOE. 



    With this massive increase in short-dated option volume, specifically with expirations less than 24 hours, intraday volatility seems inevitable. In fact, this gives an explanation for the increased intra-day volatility equity markets are seeing. 

    While the market effects of increased options trading in these contracts are not directly quantifiable, these derivates are likely causing drastic moves in the underlying assets, specifically the S&P 500. 



    In a period of heightened uncertainty about the global economy, volatility is expected. Yet common measurements are failing to record extreme intraday volatility. The culprit lies in the rise of 0DTE options.

    In the next part, we will discuss the mechanics of 0DTE options and their impact on intraday volatility.