JPMorgan: “zero-day” options contracts would sink SPX

Stock market conditions are not optimal for conventional investing due to volatility. As such, a growing number of investors are betting on “zero-day” options contracts to profit from rapid movements. But that play could be dangerous, JPMorgan analysts warn.

Taking advantage of market volatility can become a high-risk gamble on investors’ capital. This becomes more palpable as that trend expands within the market and encompasses billions of dollars. The result could be a massive drop in the S&P 500, warns Marko Kolanovik, a strategist at the bank.

Quoted in Forbes, the analyst said in February that the situation could lead directly to a “Volmageddon 2.0”. By this he refers to two terms (volatility and armageddon) and refers to a reedition of a situation similar to that of 2018. Back then, such options became very popular and resulted in the SPX index falling -4%. At the time, it was the largest drop in approximately two years.

The danger of zero-day options contracts

Contracts of this type of short options could translate into problems for all SPX investors and not only for holders. For the aforementioned expert, the drop could be much larger than in 2018, given the current delicate conditions in the stock market. Economists predict difficult times ranging from a recessionary situation to stagflation in the economy.

That creates a surge of volatility that can pay off big if capitalized on with short options. In that sense, “zero-day” options, also known as 0DTE are call or put options that expire 24 hours after entry. They also rely in many cases on massive intraday swings to realize their potential gains.

According to JPMorgan’s research, an estimated $1 trillion equivalent in 0DTE is being bought daily. This is what the analyst is referring to when he speaks of a “Volmageddon,” as the magnitude of this buying and hypothetical liquidation could drive the stock to the floor.

Consequently, a -5% intraday drop in the S&P 500 could lead to a massive $30 billion sell-off in short options contracts. At the same time, it would also bring another -20% plunge to the benchmark index, Peng Cheng wrote in a note to JPMorgan clients.

That’s a situation that would send markets into a downturn worse than a new round of rate hikes could trigger. Worse would be the matter if both scenarios combine, i.e., the collapse of short options and the announcement of an additional round of rate hikes by the Fed.

BofA has a totally different view

While JPMorgan talks of an Armageddon brought on by a hypothetical collapse of short options as in 2018, there are also differing opinions. Prominent among them is Bank of America, whose strategists wrote in a recent note that 0DTEs are generally very balanced. In other words, they do not pose a downside threat to the SPX.

“The trades are more balanced and complex than a market that is simply a series of one-way bets on rare one-day swings,” they wrote. Either way, what cannot be disputed is that the market is highly prone to sharp intraday moves. The latter creates the conditions for such short contracts to proliferate widely among investors.

To get an idea of the frequency of these movements, it should be noted that the SPX so far this year shows convincing numbers. Thus, in this 2023 it had losses or gains of 1% that exceeded 20 times. This is a colossal figure compared to the 7 times of the same period of the previous decade. This translates into an opportunity for more experienced and risk tolerant bettors.

Regarding this last point, Cheng says that the 0DTE option contract strategy is indeed an institutional trend. Thus, 90% of zero-day options are being written from the sidewalk by large investors, while retailers are focusing on long-term options.

The fear of a black swan liquidation

The fear that 0DTE short options could trigger a black swan liquidation, i.e., sudden and rare, is not unique to JPMorgan. Analysts from various portals believe that these trades tend to add extreme volatility to the market, which could result in unintended consequences.

The fact that the 0DTEs do not necessarily translate into a collapse of the SPX, as BofA claims, increases the danger. The point is that black swans cannot be predicted by statistical models or historical extrapolation. They are unique and simply happen and leave investors with little chance to react.

Although some institutions seek to calm investors’ spirits, some experts, such as Doug Kass of Real Money Pro, are emphatic. Embedded within this scenario is the danger of leverage. It is worth noting that leverage is not a negative thing, but neither is it a positive thing; it all depends on whether the investor is wrong or not.

Kass is in no doubt:

“The recent proliferation of 0DTE (zero days to expiration) options, the tail wagging the market dog has become a dangerous force… Whether you call it speculation or manipulation, it is generating extreme and unpredictable intraday volatility. My experience is that this type of contrivance ends very badly for trading rates and for our market.”

Be that as it may, zero-day options contracts remain alarmingly popular with high-status investors. Whether the outcome will be the worst for the stock market is vague. In the meantime, Wall Street continues to discuss this mode and the momentary advantages it is providing to big money.