Exclusive-Wall Street examines risks around short-dated options as warnings rise-sources

© Reuters. FILE PHOTO: A street sign for Wall Street is seen outside the New York Stock Exchange (NYSE) in New York City, New York, U.S., July 19, 2021. REUTERS/Andrew Kelly/File Photo

By Carolina Mandl and Laura Matthews

NEW YORK (Reuters) - An explosion in trading in a type of equity derivative security in recent months has prompted Wall Street players and a major clearing house to examine the potential risks it poses, according to two sources familiar with the matter.

So-called zero day to expiry options (0DTE), which refers to contracts that expire in less than 24 hours, offer retail and institutional traders a relatively cheap, though high-risk, way to bet on intra-day swings in stock prices. They could be tied to the price of indices, exchange traded funds or single stocks.

Some have warned that this type of option, which offers an opportunity for traders to amplify market bets, could cause an extreme selloff.

In one example, analysts at JPMorgan (NYSE:JPM) said earlier this week such trading can supercharge volatility in U.S. stocks - potentially turning an intraday 5% drop in the S&P 500 into a 25% rout.

The possibility of such a selloff has stirred worry, prompting major players in the derivatives market to discuss exposure and risk to the broader market on at least two calls, two sources told Reuters.

The Futures Industry Association (FIA), a trade group that includes major Wall Street players as well as the OCC as members, invited OCC to participate in a call about 0DTE at a meeting on March 1, both the OCC and FIA confirmed. Members of the FIA include the major banks on Wall Street.

"We are following the rise in volumes in these products to better understand any risk management implications for the markets and continue to have an open dialogue with our members," the OCC spokesperson said. The OCC declined further comment on the substance of its "private calls with clearing members."

As a clearing house, the OCC settles and guarantee options contracts, working as a central counterparty for credit risk.

An FIA spokesperson said that 0DTE was one of the topics discussed last week, describing the call as routine.

Apart from the group meeting with the FIA, the OCC has also discussed this issue individually with some market participants, one of the sources said.

On one of the calls, the source said that participants were exploring potential systemic risk, including if prime brokers would be able to detect clients' total exposure. The OCC told this person it did not see a major risk, but it wanted to assess its members' views and explore different risk scenarios.

The participants that talked with the OCC concluded existing safeguards would be sufficient, the source said.

VOLUME SURGE

The daily volume of 0DTE contracts on the S&P 500 (SPX) increased from around 400,000 in January 2022 to approximately 1.2 million in March 2023, representing a three-fold increase in daily volume, according to data from OptionMetrics. 

The calls with the OCC underscore a desire by options market participants to gain a deeper understanding of a corner of the market where both retail and institutional players are looking to profit from intraday market moves.

Many 0DTE options have a low probability of rising in value as they approach expiration. However, small changes in the price of the underlying stock or index can cause their prices to also change. A large intraday market move could cause contracts to suddenly rise in value and expose their sellers to increased risk of big losses.

Analysts at JPMorgan have estimated that a large market move would cause these options positions to spark buying or selling of about $30 billion, delivering what could be a volatility shock.

Others, however, said such a rise in volatility would be short-lived and unlikely to pose any systemic risk since 0DTE contracts expire daily, limiting the scope for positions to build up over time.

"Many of the volatility-selling strategies we see in this market are in the form of spreads that limit the downside of the seller," said Robert Knopp, co-head of the S&P options desk at Optiver, a market maker.