Why Zero-Day Options Are Taking Over

There's a new player in town: zero-day options. These are essentially one-day bets on market movements, and they've absolutely exploded in popularity.

They now make up about half of all S&P 500 options trading, up from just 5% in 2016. That's not just growth - that's a revolution in how people are trading.

What's the Big Deal?

Think of zero-day options like a same-day betting slip for the stock market. They expire by the end of the trading day, making them perfect for traders looking to make quick profits or hedge against sudden market swings. It's like playing poker, but with market movements instead of cards.

In February 2021, CBOE rolled out what they called the "Automated Improvement Mechanism" – fancy talk for making it easier and cheaper for smaller traders to get in on the action, smoothing out the traffic and cutting costs for everyone involved.

The real game-changer

In May 2022, Chicago Board Options Exchange (CBOE) decided to shake things up. They made these options available every weekday (instead of just three days a week) and made them more accessible to smaller traders. It's like they opened up a fancy restaurant to the masses - suddenly everyone wanted a seat at the table.

The results have been staggering. Today, nearly half of all S&P 500 options trading involves these zero-day contracts. That's not just a trend – it's a revolution in how people trade.

While this phenomenon is mainly happening in the U.S. right now (CBOE is the biggest options playground in the world), everyone's watching to see if markets in the UK and elsewhere will follow suit.

Improved market conditions have sparked a wave of innovation and attracted more participants to the financial markets. In September 2023, the first-ever exchange-traded fund (ETF) focused on zero-day options debuted, tracking the Nasdaq 100 Index.

This milestone opened the door for a range of zero-day options-based products, covering everything from stock indexes to commodities and U.S. Treasury bonds of varying maturities.

The success of these products hints at a future where even more creative zero-day options investments could hit the market.

A Boom in Retail Trading

Retail investors have embraced options trading like never before, fueled by the excitement of the meme stock frenzy and the inherent leverage that options offer. According to Beckmeyer et al. (2023), zero-day options now account for over 75% of all S&P 500 options trades made by retail investors.

The Chicago Board Options Exchange (CBOE) estimates that retail traders make up more than 30% of the total trading volume in S&P 500 zero-day options. These numbers underscore the growing appetite among everyday investors for fast-paced, high-stakes trading strategies.

Zero-day options, with their super-low prices and super-fast expiration, are like a lottery ticket for traders who crave excitement. They're cheap, sure, but that's part of the illusion.

The danger of zero-day options. While they seem affordable, the costs of playing – those tiny fees for each trade – can quickly drain your wallet.

In fact, a recent study found that a whopping 60% of losses for everyday traders using these options are directly linked to these hidden costs. So, before you dive into this high-risk, high-reward world, remember that the "bargain" might not be as cheap as it seems.

While zero-day options might seem like an exciting new way to trade, they're raising some serious red flags among market experts.

Here are four scenarios that should make us all think twice:

1. The Market-Maker's Dilemma

These options are incredibly sensitive to even the slightest market shifts. So, when the market suddenly swings, the market-maker has to frantically adjust their position to stay balanced.

Market Makers like Citadel and Jane street constant buying and selling to hedge these options can create more volatility in the market itself. While their aim is to stabilize the market, their activity can amplify price movements, creating a feedback loop where minor fluctuations escalate into significant disruptions.

2. The Domino Effect

Remember 2008, when problems in one corner of the market spread everywhere? Zero-day options could create similar chain reactions.

If the market takes a sudden dive, big financial institutions might need to quickly sell off other investments (think Treasury bonds or blue-chip stocks) to cover their losses. It's like pulling one brick out of a wall – you might end up destabilizing the whole structure.

3. The Margin Call Time Bomb

Our current system for managing trading risk was built for a slower-paced market. It's like using a sundial in the age of atomic clocks.

Most margin calls (demands for more collateral) happen once a day, but zero-day options traders are opening and closing positions every hour. See the problem? By the time the system catches up, it might be too late.

4. The Regulatory Blind Spot

The current rules (known as Pillar 1) only look at end-of-day positions to determine how much capital banks need to keep safe.

But with zero-day options, the real action happens during the day. It's like trying to judge a Formula 1 race by only looking at the starting and finishing positions.

Why This Matters

We're not just talking about sophisticated traders losing money here. These risks could snowball into something that affects everyone's investments, retirement accounts, and the broader economy.

The big question now isn't whether zero-day options are here to stay – they clearly are. It's whether this fast approach to options trading will spread globally, changing how people around the world interact with the market. What do you think? Are we looking at the future of trading, or is this just another Wall Street fad?