David Jane
Premier Miton Macro Thematic Multi Asset Team
What on earth are 0DTEs?
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Stock prices form fractal like patterns, they do not follow a random walk. Fractal patterns are natural phenomena they appear in nature as ferns, trees, snowflakes, lightning, river deltas. With a fractal, a pattern is repeated at smaller or larger scale.
Patterns which appear on a long term annual or monthly chart repeat on weekly and daily charts, through to intraday charts. In its simplest sense you can say trends persist, until they do not, and then a new trend emerges. This is true of very long-term trends, medium term and even intraday. Understanding this is fundamental to active fund management. Our process consists of macro trends and themes in the context of an understanding of the long-term environment.
Higher for longer
In our view, the long-term pattern is currently higher for longer, higher inflation, higher rates. This guides our basic portfolio construction, with a focus on real assets. That does not mean there will not be periods where that trend reverses in the near term, as it may be currently, as inflation comes down from a short-term peak. This pattern of inflation spikes and declines is expected to continue for the time being. This will guide the pattern we expect to see for long term asset class performance.
At the next level we consider shorter term macro trends and technological and demographic themes. These tend to have a shorter-term rhythm that guide many of our sectoral, regional and stock selection decisions. Themes such as reshoring back to developed markets and the changing structure of energy markets guide our selections within assets classes.
At the micro level we have the behaviour of markets in the very short term. This is an area where we do not attempt to add value. It is, however, important to us for risk management. When a particular theme is especially in favour we might trim our level of investment to contain risk for example.
Zero days to expiring options (0DTE)
This brings us to today’s topic. Short term trends are being heavily impacted by a new innovation in financial markets, zero days to expiring options (0DTE). These are a short-term speculator’s dream, as the short term to expiry means they are relatively low cost compared to longer dated options.
In essence a trader can access huge amounts of leverage to near term price movements with downside limited to the minimal cost of the option. Consequently, they have proven extremely popular and now dominate options trading and overall equity trading. It also is likely a major reason why volatility, both derived and actual has remained relatively low
Such an innovation does not impact market price levels, as for every buyer of the option there is a seller who will hedge their position in the cash markets. What it can impact is the pattern of trading. Previously, when option trading was dominated by one-month expiries, there was a peak in volume on expiry days as counterparties settled their positions.
Now we see this pattern intraday as both put and call buyers book gain intraday, effectively meaning daily price movements tend to be anchored around levels where the peak of option interest lies. The effect of this is to dampen daily movements but create large intraday swings as both buyers and sellers close their positions. Only where ‘real money’ buying and selling dominates will this stable pattern be broken.
A repeating pattern?
In my experience, each successful financial innovation has gone through a similar pattern. A period of rapid growth as everyone wants to exploit the new source of profit is followed by a disaster of some kind, and a subsequent normalization (and additional regulation).
At this stage, the benefits of 0DTE options are evident for both the buyer and seller. Their overall impact of dampening volatility is probably also a benefit and they certainly enhance liquidity.
However, they also have the potential to destroy the wealth of the naïve retail or professional trader incredibly rapidly. Out of the money options with only a matter of hours to expiry are worthless to anyone but a pure speculator, so the only long-term winners are the banks that create these.
Naturally, some speculators will make money, but most must lose as the premium paid will offset any profits in aggregate. The potential to transfer wealth from the public to financial intermediary rapidly is immense. The bigger question is whether there will be a substantial resumption of volatility. Most previous innovations have led to such an event. Portfolio insurance, Collateralized Loan Obligations (CLOs), Collateralized Debt Obligations (CDOs) all had to go through a moment of stress, before maturing.
We are happy to observe from the side-lines as we do not get involved in derivatives or speculations in general. We are, however, alert to the possibility that the volatility dampening effect of this innovation can rapidly reverse, as has been the case with past financial innovations.
