How "0DTE" Options Will Cause the Next Black Monday

Portfolio insurance in 1987

One of my first reactions to hearing of the recent popularity of 0DTE trades was to recall Black Monday and the 22.6% crash of the Dow Jones Industrial Average on October 19, 1987. There were several causes for the crash, but the factor that significantly amplified the decline was portfolio insurance.

At the time, institutional investors were buying portfolio insurance from Wall Street brokers to protect against losses. During market declines, the brokers' computer algorithms would automatically sell S&P 500 futures contracts short. As the market sold off further, the algorithms would sell more contracts.

As the programs sold, they pushed markets lower, necessitating more portfolio insurance-related selling. Selling begat selling, and a correction turned into an avalanche of panic.

The following quote is from a Wall Street Journal article rehashing the crash:

The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time. They pushed stock prices into free fall and individual investors under the bus.

0DTE options

The popularity of 0DTE options is rising precipitously. As the graph below shows, half of the volume of options on S&P 500 futures are 0DTE. That dwarfs the 5-10% share before the pandemic.

Individual and institutional investors are using options that have a very short time until expiry for speculative and hedging purposes. It is also likely investors may be using 0DTE options to manipulate markets. Regardless of the drivers, 0DTE options are similar to portfolio insurance; they can significantly intensify market moves.

To reiterate the WSJ quote: "The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time."

Sound familiar?

How manipulation creates instability

To appreciate the risk of 0DTE options, let’s walk through a hypothetical example using Tesla stock. This case uses data from the early afternoon on January 25, 2023. After the close that day, Tesla reported its quarterly earnings.

Hypothetical hedge fund ABC owns 100,000 shares of Tesla stock (TSLA). TSLA was trading for $144, which meant ABC had a $14,400,000 investment in TSLA. With earnings due shortly, ABC wanted a low-cost trade to juice their returns if earnings were better than expected.

One way was 0DTE options. To do so, it could buy calls with a $160 strike that expired in a day. At the time, the price per 0DTE call was $1.36. Each call option controls 100 shares. Buying 1,000 calls gave them the right to purchase 100,000 shares at $160. The options cost $136,000 or about 1% of its Tesla investment. If TSLA shares flopped on earnings, it would lose 1% on the options. If the stock rose, it would likely sell the options and easily double or triple its 0DTE investment. More importantly, the calls could force significantly more buying if the stock rose.

Delta hedging begets delta hedging

As frequently occurs, ABC indirectly buys calls from a Wall Street dealer. Most dealers run managed books, meaning they have limited risk-taking tolerance. Accordingly, they often hedge their risks. In this case, the dealer's risk is an increase in the price of Tesla.

Dealers use a method called delta hedging. An option's delta estimates how much its value may change for a $1 move up or down in the underlying security. The delta at the time of the trade was .15. For each $1 that TSLA shares rose, the options would increase by 15 cents. The delta increases toward 1.0 as the price approaches the strike price and falls toward zero as the price declines.

The dealer might initially delta-hedge the calls in our scenario by buying 15,000 shares (.15*100,000). As the price rises or falls, the number of shares it owns will change according to the delta. The table below approximates the delta for Tesla shares on that day for a range of prices.

If the hedge fund was right and Tesla had excellent earnings, the stock would jump and force the dealer to buy more Tesla. The further it rises, the more shares it must buy. As that and other dealers increased their hedges, the buying pressure on Tesla shares would increase and push the delta higher.

Buying begets buying.

Options on the market

The Tesla 0DTE example pertains to the movement of one stock. While Tesla's price may be more volatile than it would have been without 0DTE options, its effect on the broad market is limited.

More concerning are investors are buying 0DTE calls and puts on the S&P 500 and other indexes. Often such options are purchased in advance of potentially market-moving events. Recently, CPI, Fed meetings, and employment reports have elicited sizeable flows from 0DTE traders.

Suppose 0DTE volume is large enough, and options buyers are betting on the same directional market move. In that case, the environment becomes ripe for significant market instability if dealers are forced to aggressively delta hedge. Adding strength to such an event, investors become irrational when markets fall precipitously. A considerable downward move could trigger other investors to panic sell. Selling could beget selling, and a few percent loss could quickly turn into a severe decline.

Summary

For every option, there is a bank or dealer on the other side of the trade. Risk management protocols force dealers to buy or sell up to 100 shares of the stock or index for each option. It takes little money for a hedge fund to manipulate stock or index prices and, therefore, to create market instability.

Unlike portfolio insurance, delta hedging is limited as the delta can only go to one or zero. However, a heavy dose of delta hedging could cause panic selling among other market players.

Fear can beget fear!

Closing note

When I calculated the TSLA 0DTE example, Tesla closed the day at 144.43 minutes before the company reported its Q4 earnings. Its shares shot 10% higher the next day on the most volume in six months. 0DTE certainly helped TSLA shareholders!

Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.

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