0DTEs add to ‘hedging toolbox’, appetite for SPX Vega remains

Market analysts have sounded the alarm as the craze for zero-day to expiration contracts, known as zero-day contracts or 0DTEs, is bringing new volatility to the wider equity market and having an impact on how underlying assets behave.

For trading desks hedging structured products, 0DTE options are not a game-changer, but one potential hedging instrument among others used by traders.

“Their recent surge provides with an additional tool in the dynamic hedging toolbox, for the potential short-dated residual exposures, but our products typically entail longer maturities,” said Pierre Gimenes, global co-head of structuring for global markets, at SGCIB.

This, however, means that “structured products trading books would not be the major actor in that vol market segment”, he said.

“Given the investment terms of structured products these options would have limited use,” said a senior market source. “However, all structures must be hedged on the last day before maturity – the strikes and barriers in 99% of the products are in or out of the money and don't need further hedging. However, if the product has touched the barrier then 0DTEs can be used for hedging.”

According to Kris Sidial, there's two potential ways as of how the increased use of 0DTE options affects the structured products market and issuers of structured products.

“I don't think necessarily that the structured products market is selling vol via 0DTEs but they're selling shorter dated vol like one-month tenors that they'll look to sell to hedge their gamma exposure a little cleaner,” he said. “So, they can have their big exposure hedged, but if their gamma exposure starts getting a little bit crazier, 0DTEs can help them to be a little more flexible in reinforcement.”

Dynamic hedgers have a little bit more of an efficient way to hedge their portfolio and the dynamic hedges are usually the ones that are issuing the structure product notes, added Sidial.

A senior banker for a leading European investment bank and issuer of structured products confirmed that the use of daily options to hedge discontinuities - recall barriers, down and in puts (PDI), gap limits - on the S&P 500 is now part of the day to day.

“There are several reasons for that,” he said. “[0DTEs] have good liquidity, the strikes are tight, and the observation is at close, as on our structured products.

“However, we do not wait for the day of the expiry to trade them, we tend to do it earlier (days or week before the event date) to avoid having a large gamma exposure.”

Hedgers/sellers

One of the reasons why 0DTEs are mainly traded volume wise for indices is because of the higher option demand from hedgers and sellers of structured products.

“What we noticed in the data is really that so, a lot of the activity is around 2% slightly out the money on the call side and 2% slightly out the money on the put side,” said Sidial. “And the data shows that at the beginning of the day, there is a lot of people coming in to sell volatility.

“It seems like the bulk of this flow is coming from wealth managers and volatility hedge funds – mostly speculative vol hedge funds and some market makers and a very small percentage of retail.”

Ambrus Group has just published a new research paper analysing and demystifying “the truth behind 0DTE options and what it means for the market going forward”.

“Our research shows that retail is not behind the bulk trading of these 0DTE options,” said Sidial. “And what you will notice throughout the course of the day is that people will look to cover these positions and then you'll notice a second wave of buyers that will come in and try to bet in favour of the trend. So, if the market was up 1% going into the middle part of the day, you'll see a lot of people come in and try to buy calls or vice versa if the market was down 1%.”

According to Sidial, the behavioural pattern is that beginning of the day, “you have a lot of people coming in and they're selling volatility at the beginning of the day”.

“Midway throughout the day, they're looking to close some of these positions. And then you have a second wave of participants that come in and they'll try to buy the continuation of the trend,” he said.

Another common misconception pointed by the report is the idea that investors are hedging their risk with 0DTE options instead of VIX calls.

Sidial pointed to the mini banking crisis of March 2023 as a scenario where 0DTE options would not be a reliable hedge.

“In fact, during that brief moment we witnessed one of the highest amounts of VIX call buying over the last three years, demonstrating that investors will still rely on 30-day volatility during times of instability and panic,” he said.

“Although these options are not impacting the VIX derivatives complex, the addition of 0DTEs does seem to have had an impact on the SPX complex.”

Generally, the Vega is greater in longer-term options whereas shorter-term contracts carry a higher gamma profile - due to the short-term nature of 0DTE contracts, they do not carry a large Vega profile.

“Even with all of the active trading that takes place, it seems that the Vega from 0DTE options is not disrupting the breakdown and appetite for SPX Vega,” said Sidial.

!Since most of the contracts traded are slightly OTM, they carry a very high amount of delta and gamma risk which can impact the market. This can be observed in the big intraday price swings in the underlying which occur as a result of market makers hedging their exposure to these contracts.”

Fuelling vol… in stress conditions

The report has an interesting twist as it found that on regular market days and regular scenarios, the increased 0DTE activity is not adding a sense of hazard but during moments of true market stress, “they absolutely act as an additive fuel to the fire”.

“The misconception is that we could wake up one day and 0DTS could just drive the market down 20% and that from what we're seeing in the data is actually not true,” said Sidial. “But if we have a scenario where the market is down, 5% or there is a market crash the new phenomenon could help accelerate volatility.”

According to Sidial, it is not really a “volatility creator, but a volatility accelerator”.

“For us, those imbalances and the extra vol provide an opportunity to extract value from the market, but maybe not for other market participants,” he said.

“We have not witnessed that kind of vol over the last two years or the S&P500 down 5-6% on a pretty extreme catalyst. But these options have been put into play and eventually we will run into the day where that sort of additive fuel will add the reflexivity and as a vol fund this could work out favourably for us.”