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WALL STREET’S HOT NEW THING

New finance just dropped

You don’t normally think of the finance industry as “inventing” new things. If anything, most people probably think the financial system is bloated and unnecessarily esoteric.

On that point, I present one example: Zero-day-to-expiration (ODTE) options. Many wrongly interpret what happens across Wall Street as gambling — for the most part, there’s a good reason why various aspects of the financial system exist, and what looks like gambling often has at least some plausible explanation.

The same cannot be said for zero-day options. While wonky and technical sounding, the idea is very simple and has become extremely popular lately.

Citi Bank recently found that zero-day options have reached a record share of U.S. options market volume at over 40%.

As Ethan Wu of the Financial Times puts it, these have become “absolutely huge…There’s no two ways about it.”

What are options?

First of all, let’s cut through the jargon and define what an option is in investing. The standard explanation is that an “option” is a type of financial contract, allowing (but not requiring) you to buy or sell a stock/ETF at a certain price.

To some, they’re a tool for making leveraged bets, where you spend a small premium to bet on a stock’s price moving in a given direction in the next 90 days, and if it does, you can unlock a much larger than normal payoff.

The catch? If you’re wrong, the option is worth nothing — your investment goes to zero.

To others, options are more like an insurance contract, protecting them from certain risks. If you have $100k invested in Apple stock and don’t necessarily want to sell your shares but want to reduce how much you’d lose if the stock hit a rough patch, then you might pay a small premium to buy options betting against Apple’s stock.

That way, if Apple’s shares do sell off, you get an insurance payout offsetting your personal losses. If Apple’s stock keeps rising, the premium you paid for those options goes to waste, but it’s a small price to pay for extra protection and peace of mind in investing.

There are many other tactical reasons to use options, but those are the two broad buckets: Leveraged bets and portfolio insurance.

In both approaches, the common element is time. Like a term life insurance policy or car insurance, financial options expire, imposing a time constraint on how you use them.

More time gives you more room for your options bet to pay off, but that extra flexibility comes at an added premium. Typical options contracts expire in a few weeks or months.

Using zero-day options

But zero-day options remove that time buffer. You make a bet, and it expires at the end of the day. Maybe you think the S&P 500 will rise 1% today, so you buy a zero-day option connected to an S&P 500 ETF that expresses your bet.

Even if the S&P 500 goes up 0.95%, your option bet would expire worthless — whatever you spent would be totally gone after just one day. (For the option to be profitable and not expire worthless, the S&P 500 would have to rise 1% or more.)

In this case, to pay off, your options bet has to hit and exceed a specific price target within a very narrow timeframe (one day).

If you think that sounds like gambling, I’d guess almost no one would argue with you.

As Ethan Wu says, “the appeal kind of lies in the fact that because these zero-day options are so short-dated, they’re also really cheap. You can turn a tiny little upfront investment into a really big gain.”

He adds, “With stocks, it’s very rare that you’re going to lose everything, at least right away, whereas with an option, that could easily happen. That could happen the day you buy it.”

Who’s doing this?

Robin Wigglesworth, also from the Financial Times, compares the phenomenon to sports betting: “You just wanna put money on what’s gonna happen in the match today, not the match in two or three weeks’ time.”

On internet forums like r/WallStreetBets — of 2021 meme stock fame with Gamestop — zero-day options are a popular way to make short-term bets. And as a result, these amateur “investors” are consumed by the pitfall of gambling more than they’re investing.

Wigglesworth comments, “Certain things are eternal truths in financial markets, and (amateur) traders getting their faces ripped off by…hedge funds. That’s never gonna change. Zero-day options is just a very efficient way of doing so.”

Is a crisis looming?

New financial innovations of the past have often been abused and created feedback loops that accelerate or even cause market crashes.

But Wigglesworth doesn’t exactly see the same risk here, commenting that although he’d love to see zero-day options blow up because they’re “dumb,” he “find(s) it hard to really think this is gonna be a major disaster.”

Instead, the problem is that zero-day options have no societal value. Day-trading a stock, while also of little value, at least adds to a market for a company’s stock, which can sell more shares of stock into the market to raise real money for its business.

The same generous view of social value cannot be extended to zero-day options.

Like lottery tickets, they’re really only for entertainment purposes. And apparently, many people find them entertaining.

Dive deeper

For more, check out the full Unhedged podcast episode with Ethan Wu and Robin Wigglesworth.

See you next time!

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