In the ever-evolving landscape of markets, new trading instruments emerge, bringing both opportunities and challenges. One such instrument is the 0DTE option, a derivative introduced in 2022 that has gained significant traction, accounting for nearly 50% of daily trading volumes in the S&P 500 (SPX). While these options have brought liquidity and flexibility to the market, their influence has also led to certain unintended consequences, artificially suppressing volatility and fueling a self-reinforcing feedback loop.
The Power of 0DTE Options
Zero days till expiration options, commonly referred to as 0DTE options, have captured the attention of market participants due to their unique characteristics. By offering the ability to trade options with expirations on the same day, they allow traders to capitalize on short-term price movements without holding positions overnight. This inherent feature grants them significant gamma exposure, creating a powerful tool to control volatility artificially. If you’re unfamiliar with gamma, you can read more about those market dynamics by clicking here.
The Rise of Passive Funds
Simultaneously, another force has been reshaping the market landscape: the ascent of passive funds. These investment vehicles, driven by computer algorithms and now commanding approximately 70% of daily trading volumes (compared to 24% a decade ago), operate with a distinct strategy. They tend to buy stocks when volatility is low and sell when volatility is high, seeking to track broad market indices. As these funds dominate trading activities, their actions intertwine with the impact of 0DTE options, forging an intricate relationship.
A Self-Enforcing Feedback Loop
The combination of 0DTE options and passive fund strategies has given rise to a self-enforcing feedback loop. When 0DTE options suppress volatility through gamma exposure, passive funds interpret the low volatility environment as a signal to accumulate stocks. This behavior perpetuates the cycle, pushing the market to extraordinary, sometimes unnatural, highs. What ensues is a marketplace increasingly divorced from organic fundamentals, where prices are divorced from underlying risks and long positions become overcrowded.
Unmasking the Dangers
Amidst the dizzying heights of the stock market, a sense of caution emerges. The inorganic nature of this activity poses significant risks and raises red flags. Artificial mispricing of market risk becomes a pressing concern, as the true underlying dynamics are masked by the interplay of 0DTE options and passive fund strategies. The prevailing sentiment is one of a ticking time bomb, where an unexpected event could trigger a lightning-fast reverse action, potentially leading to a market downturn. The rise of 0DTE options has very much become a “tail wagging the dog” moment.
The Retail Trader’s Dilemma
Compounding the issue is the growing influx of unsuspecting retail investors drawn into this whirlwind of market activity. As stocks surge to unprecedented levels, the allure of potential gains becomes hard to resist. However, many retail investors may be unaware of the underlying risks and distortions in play. Unbeknownst to them, they could unwittingly become participants in a market environment ripe for volatility shocks and sudden reversals.
That being said, common trading tenets can keep traders safe. It is cliche at this point but still holds incredible validity: Trading with the trend, setting stops, respecting your rules, etc are all ways to avoid outsized drawdowns or account blowups.
Should retail traders watch 0DTE SPX options activity?
Options activity has exploded in recent years and is only going to increase. Many are wondering about the significance of monitoring 0DTE SPX options activity, or whether they should be trading these instruments. While these options provide unique trading opportunities, their intricate relationship with passive fund strategies and the potential for market distortions make it crucial for retail traders to exercise caution. Retail traders should be aware that the interplay of these options and the dominance of passive funds can amplify market volatility and lead to sudden reversals.
Since the introduction of these daily expiring products, I have personally moved 100% of my index trading to ES futures - My only regret with this decision was not doing it sooner. While the interplay of 0DTE options, passive fund flows, and the impact that gamma has is quite interesting, I have not found there to be any real edge in this information. Many of the “gamma levels” are obvious psychological levels or clear technical levels on the chart. After spending a couple of years studying and trading with this data, I found myself gravitating back to what has been a simplistic yet profitable approach: order flow and technical analysis. As mentioned, there was no discernible trading edge in this information that was not already present in my current system. With that finding in mind, retail traders are far better off studying price action than options activity or gamma levels.
Conclusion
The emergence and proliferation of 0DTE options have introduced a new dimension to the financial markets. While they offer unique opportunities for traders, the interplay between these options and the dominance of passive funds has generated a self-enforcing feedback loop. This loop fuels market distortions, suppresses volatility, and artificially misprices underlying market risks. While this feedback loop is interesting and may have market-wide repercussions at some point - There is no real advantage for retail traders to incorporate this data into their system. Gamma levels align with clear areas of supply and demand (or support and resistance) on the chart, and price action tells us who is in control of the tape.