There is more and more noise about the rise of the 0DTE options (zero day to expiry). According to JPMorgan, their daily notional value is around $1trillion and they represent more than 40% of the daily option activity on the S&P500. That staggering number could turn a 5% down move into a 25% rout.
In theory, the more financial instruments are available in the markets, the better. it makes markets more “complete” and a wider diversity of risks can be hedged out or transferred.
To retail investors, 0DTE options are comparable to lottery tickets. For a small dollar amount, you can buy out-of-the-money calls or puts and potentially realise a big gain if you are right. It can be a very interesting game around earnings or news releases. Even though you will most likely overpay for those options on average, you could be lucky and make big money. If you lose today, you can play again tomorrow. Like at the lottery.
But lotteries have rules. For instance, the French lotteries have an overall payout ratio that is capped at 50%-72% for the draw games, which ensures the stability of the lottery system.
With 0DTE options, you cannot control the payout ratio. because you cannot control the size of the jackpot and you cannot control the odds. In a Black-Scholes world (happy 50th anniversary!), you could ontrol the odds: you perfectly know the behaviour of the underlying stock, and the trader can replicate perfectly the option payout by buying and selling the stock: in other words in a Black-Scholes model, the risk miraculously disappears when it touches the fingers of a derivatives trader. Reality is very different. If a significant number of retail investors (or anyone else) would buy an OTM put ahead of some bad news. The “natural” market move down would be exacerbated by traders having to sell more to hedge the short put. That would then trigger potential stop losses and the most commonly observed human bias: momentum. Most sellers would come in betting on a further move down. In other words, in the 0DTE lottery, the number that most people are betting on gets more chance to be drawn ! How bad is that for the lottery system ?
Lotteries are efficient, markets are not !
