April 1st, 2023: Daily Options Trading: The New Meme StockAs we review the stock and bond markets this week, it appears that investors are already pricing in the recovery even before the supposed recession hits. Market volatility has been well over 1% in either direction on any given day. I believe this is largely due to the increased trading volumes of shorter-dated options contracts. These options, also known as zero-day-to-expiry options or 0DTE options, have replaced “meme stock” investing and now account for almost 50% of all options traded.
While well-timed daily options can produce 1x, 2x, and even 3x daily returns, this week those daily options hit well over 5x. For example, let’s say that today is Friday, and the current price of the SPDR S&P 500 ETF Trust (SPY) is $400. An investor interested in trading daily options might consider buying a 0DTE call option on SPY with a strike price of $402. The premium for this option might be around $0.50, which is a cost of $50. If the price of SPY rises above $402 before the end of the trading day, the investor would make a profit on the option. For instance, if SPY rises to $406 by the end of the day, the investor would be able to exercise the option, buy shares of SPY at $402, then sell them on the market for $406, earning a profit of $350 ($400 minus the $50 premium paid for the option). The leverage created by this speculator is that at a $50 cost is equivalent to a $40,000 position (100 shares x $400) in SPY. In most cases, the speculator is buying multiple contracts. For example, following the example above with only $1,250 (25 contracts at $50) in a small brokerage account, a day trader can be long $1,000,000 in the SPY (25 contracts x $40,000) if the options move into the money, which would be a market move from $400 to over $402. At this point, every dollar move up over $402 in SPY would be a $2,500 profit (25 contracts x 100 shares). I realize that this example might be confusing, and it would be for most people trading these options, except that trading platforms such as Robinhood have gamified trading with visual graphics that help users easily understand profit and loss scenarios.
On the other hand, if the price of SPY does not rise above $402 by the end of the day, the option would expire worthless, and the investor would lose the $0.50 or $50 premium paid for the option. In my example, the day trader would lose the entire $1,250. This is the risk associated with trading 0DTE options – they are highly speculative and can result in significant losses if the market does not move in the expected direction. The intra-day moves of moving up and down over 1% are now the norm. The Reddit day traders that started the meme craze are now all over these options, and the masses are now being educated on daily options.
You might be wondering what could possibly go wrong because in these markets, something this speculative eventually breaks. It is essential to note that the risk of a fat-tail event is increasing. Fat tails refer to the extreme ends of the distribution being hit and are becoming much more common, particularly when the market moves in one extreme direction. As such, I would now be very hesitant to “sell” any put options to someone betting on a fat-tail event. For instance, if markets get overbought, and the SPY trades to say $420, it could correct back to $400 easily in a day. This $20 daily change will wipe out the put sellers and be a potential 36x return for the put buyer. Without going into the math in this example, a move from $420 to $400 would result in a $45,000 profit on 25 contracts ($18 point move down in the money x 25 contracts). The seller of this put would be wiped out. The danger thus lies with the seller of these options. The losses are limited for the buyer but unlimited for the seller who takes the other side of this bet. This is why either overpriced or underpriced markets going forward have much more potential to correct back to equilibrium in only one day.
You might also be wondering how these options are impacting your investments. They are starting to have more and more of an impact. For example, I have observed that the once sleepy stock Berkshire Hathaway is now fluctuating over $5 on Fridays, with up to $3 movement in the first and last 15 minutes of trading. This is likely due to the fact that Berkshire only has weekly options expiring on Fridays. If daily options were available, the stock could move over $6 a day. A few weeks ago, the stock moved almost $10 down, and there was no news. These trading points will also help to create buying opportunities. Long-term investing is more important than ever with the increased popularity of daily options. While these options can provide the potential for large short-term gains, they are also highly speculative and come with significant risks. The high volatility associated with daily options can lead to significant price swings in a short period, which can be tempting to react to and adjust investment strategies in response. However, focusing on short-term price moves can be detrimental to long-term investment goals, as these moves can be unpredictable and influenced by a variety of factors, including speculation and market sentiment. Instead, successful investing will depend even more on focusing on a well-diversified long-term investment strategy. Our investment approach can help to mitigate the risks associated with daily options while still providing the potential for long-term growth and stability.
I expect the popularity of daily options may eventually lead to a Congressional hearing to educate politicians on why market volatility got out of hand on that one down day that wiped out all the put sells. It’s also possible that the fat tail is to the upside. In this case, there wouldn’t be any hearings because nobody complains about up markets. The scenario that is most likely to play out would be a spike up followed by a spike down. This way, everyone loses in the end, like all the ill-timed investors in the meme stocks in GameStop and AMC. We are not there yet, but by the looks of the gaining popularity of these options, that day is fast approaching.
Please follow and like us:
Please follow and like us:
As we review the stock and bond markets this week, it appears that investors are already pricing in the recovery even before the supposed recession hits. Market volatility has been well over 1% in either direction on any given day. I believe this is largely due to the increased trading volumes of shorter-dated options contracts. These options, also known as zero-day-to-expiry options or 0DTE options, have replaced “meme stock” investing and now account for almost 50% of all options traded.
While well-timed daily options can produce 1x, 2x, and even 3x daily returns, this week those daily options hit well over 5x. For example, let’s say that today is Friday, and the current price of the SPDR S&P 500 ETF Trust (SPY) is $400. An investor interested in trading daily options might consider buying a 0DTE call option on SPY with a strike price of $402. The premium for this option might be around $0.50, which is a cost of $50. If the price of SPY rises above $402 before the end of the trading day, the investor would make a profit on the option. For instance, if SPY rises to $406 by the end of the day, the investor would be able to exercise the option, buy shares of SPY at $402, then sell them on the market for $406, earning a profit of $350 ($400 minus the $50 premium paid for the option). The leverage created by this speculator is that at a $50 cost is equivalent to a $40,000 position (100 shares x $400) in SPY. In most cases, the speculator is buying multiple contracts. For example, following the example above with only $1,250 (25 contracts at $50) in a small brokerage account, a day trader can be long $1,000,000 in the SPY (25 contracts x $40,000) if the options move into the money, which would be a market move from $400 to over $402. At this point, every dollar move up over $402 in SPY would be a $2,500 profit (25 contracts x 100 shares). I realize that this example might be confusing, and it would be for most people trading these options, except that trading platforms such as Robinhood have gamified trading with visual graphics that help users easily understand profit and loss scenarios.
On the other hand, if the price of SPY does not rise above $402 by the end of the day, the option would expire worthless, and the investor would lose the $0.50 or $50 premium paid for the option. In my example, the day trader would lose the entire $1,250. This is the risk associated with trading 0DTE options – they are highly speculative and can result in significant losses if the market does not move in the expected direction. The intra-day moves of moving up and down over 1% are now the norm. The Reddit day traders that started the meme craze are now all over these options, and the masses are now being educated on daily options.
You might be wondering what could possibly go wrong because in these markets, something this speculative eventually breaks. It is essential to note that the risk of a fat-tail event is increasing. Fat tails refer to the extreme ends of the distribution being hit and are becoming much more common, particularly when the market moves in one extreme direction. As such, I would now be very hesitant to “sell” any put options to someone betting on a fat-tail event. For instance, if markets get overbought, and the SPY trades to say $420, it could correct back to $400 easily in a day. This $20 daily change will wipe out the put sellers and be a potential 36x return for the put buyer. Without going into the math in this example, a move from $420 to $400 would result in a $45,000 profit on 25 contracts ($18 point move down in the money x 25 contracts). The seller of this put would be wiped out. The danger thus lies with the seller of these options. The losses are limited for the buyer but unlimited for the seller who takes the other side of this bet. This is why either overpriced or underpriced markets going forward have much more potential to correct back to equilibrium in only one day.
You might also be wondering how these options are impacting your investments. They are starting to have more and more of an impact. For example, I have observed that the once sleepy stock Berkshire Hathaway is now fluctuating over $5 on Fridays, with up to $3 movement in the first and last 15 minutes of trading. This is likely due to the fact that Berkshire only has weekly options expiring on Fridays. If daily options were available, the stock could move over $6 a day. A few weeks ago, the stock moved almost $10 down, and there was no news. These trading points will also help to create buying opportunities. Long-term investing is more important than ever with the increased popularity of daily options. While these options can provide the potential for large short-term gains, they are also highly speculative and come with significant risks. The high volatility associated with daily options can lead to significant price swings in a short period, which can be tempting to react to and adjust investment strategies in response. However, focusing on short-term price moves can be detrimental to long-term investment goals, as these moves can be unpredictable and influenced by a variety of factors, including speculation and market sentiment. Instead, successful investing will depend even more on focusing on a well-diversified long-term investment strategy. Our investment approach can help to mitigate the risks associated with daily options while still providing the potential for long-term growth and stability.
I expect the popularity of daily options may eventually lead to a Congressional hearing to educate politicians on why market volatility got out of hand on that one down day that wiped out all the put sells. It’s also possible that the fat tail is to the upside. In this case, there wouldn’t be any hearings because nobody complains about up markets. The scenario that is most likely to play out would be a spike up followed by a spike down. This way, everyone loses in the end, like all the ill-timed investors in the meme stocks in GameStop and AMC. We are not there yet, but by the looks of the gaining popularity of these options, that day is fast approaching.