Risk and reward: New insights on 0DTE option trading

Options trading volume has seen a dramatic shift over the last several years, from options that expire within a month to those that expire within a single trading day. Known as “zero-days-to-expiration,” or 0DTE options, their popularity has exploded, particularly among institutional investors, note Johns Hopkins Carey Business School researchers Federico Bandi and Nicola Fusari.

“Within the S&P 500, daily transaction volume in 0DTEs is now over 43 percent of overall daily option volume, up more than 100 percent as compared to 2021 levels,” points out Bandi, the James Carey Endowed Professor in Business. 

According to J.P. Morgan Chase’s estimates released in February 2023, this corresponds to a daily notional dollar volume around $1 trillion.

Though investors are clearly paying attention to 0DTEs, academic work has been scarce. In their recent research paper, “0DTE Option Pricing,” the two researchers—together with former visiting Carey Business School professor Roberto Renò, currently at ESSEC Business School—describe the meteoric growth in 0DTEs, examine both the opportunities and the risks, and provide a new framework for valuing 0DTEs.

“It’s important to understand that very short-term options like 0DTEs are very sensitive to small changes in the price of underlying assets,” says Fusari, a professor of finance. “0DTEs offer new opportunities to traders who can now capitalize on very short-term directional bets, but also raise concerns about market volatility and the potential for sharp price swings.”

Rewards… and risks

Two decades ago, Bandi notes, most option trading was conducted within monthly maturity periods. By 2021, the timeframe had shifted to weekly expirations.

“Since 2022, every trading day, investors may trade in options that expire that very same day,” he says. The result is a liquid market of financial instruments that permits short-term bets on the direction of the underlying price process.

But, of course, there are risks. Since 0DTEs, like all derivatives, are based on the pricing of an underlying asset, perhaps the biggest risk revolves around the potential for an event—for instance, an unexpected Federal Reserve announcement of a change in market rate—to trigger large price swings within a single day.

“If you are not hedged properly, these swings could have an enormous negative impact,” says Bandi.

Some economists worry that an initial price swing could create a “feedback effect” as option sellers rush to hedge their positions after a large intra-daily market move. The researchers reference a warning made by Marko Kolanovic, J.P. Morgan Chase's chief global markets strategist, on February 15, 2023: “The growing size of the 0DTE segment may lead to sharp market swings as large as $30 billion, particularly in the current low liquidity environment.”

Understanding fair values

In their paper, the researchers offer insights on valuing 0DTEs. “The process is important for the buy side looking to understand fair values and directional bets,” they write. “It is important for the sell side and market-makers attempting to quantify risks and hedge them. It is also important for regulators wishing to assess the systemic implications of a new and extremely fast-growing market.”

They develop a model — which they test on intra-daily option data from January 2, 2014, to May 11, 2023 — that leverages earlier work by Bandi and Renò in order to formalize a new valuation framework. The framework yields, they show, “superior pricing” of 0DTEs.

Moreover, says Fusari, “Our framework offers two concrete applications. For one, it provides a way for hedging 0DTEs more effectively than existing strategies, leading to better performance in terms of profits and losses.”

Secondly, he notes, the research sheds new light on the investors’ attitudes about risk. Previous research has focused on longer-term risk-reward trade-offs, Fusari says.

“We shifted the lens to a much shorter horizon that is almost instantaneous — between the beginning of the day and the closing bell — to learn more about the instantaneous compensation investors require to be in market.”