Boom in ‘zero day’ options draws regulatory attention

The US derivatives regulator is examining the impact on markets of extremely short-dated options contracts after analysts warned the booming trend could be contributing to wild swings in stock prices.

Rostin Behnam, chair of the Commodity Futures Trading Commission, on Wednesday said the agency was assessing the potential risks or systemic issues that could arise from so-called zero-day trading strategies, which have surged in popularity since the start of the coronavirus pandemic.

Zero-day options refer to contracts that expire on the same day they are purchased and are mainly tied to the S&P 500 index. About 45 per cent of S&P 500 options volume on a typical day comes from on single-day options, according to Bank of America.

Proponents say the daily expiries allow investors to make more targeted bets or hedge risk around specific events such as economic data releases or central bank meetings but analysts have warned that the rising numbers of contracts could be magnifying violent market swings. Equity options contracts in the US are regulated by the CFTC’s sister regulator, the Securities and Exchange Commission.

Speaking to reporters at the annual Futures Industry Association conference in Boca Raton, Behnam said: “We’re talking internally about who the participants are in that market, what it potentially means from a risk standpoint, what are the obvious — if any — systemic issues . . . I don’t want to prejudge it, but it’s clearly on our radar.”

He added that more transparency around who was using the options was “the key to a successful market”.

The flexibility of short-term options has been particularly popular with investors during the past year’s market volatility, with trading volumes repeatedly hitting new records.

However, the trend has drawn regulatory attention after a series of reports by analysts at JPMorgan that compared the growth to the 2018 blow-up in options markets, known as “Volmageddon”.

A build-up of one-way bets on products linked to the Vix volatility gauge ended in early 2018 with the closure of two major investment funds after a drop in stock markets caused a sharp reversal in the Vix.

In its worst-case scenario the bank suggested that the cost of unwinding zero-day options bets could effectively turn a 5 per cent S&P 500 decline into a 25 per cent market decline.

The vast majority of zero-day trading focuses on contracts tied and are offered by Cboe Global Markets, the world’s largest options exchange. At a separate event at the FIA conference on Tuesday Cboe head of derivatives Arianne Adams dismissed comparisons to Volmageddon or the meme stock trading of the early pandemic.

She said the exchange’s S&P 500 contracts were being traded by a broader spectrum of investors and spilled between buy and sell orders, which reduced the risk of causing sharp moves in one direction.

She added that many trades were closed out before they expire, and said more than half of investors used complex spread trades that included inbuilt hedges.

A senior executive at a large market maker that trades S&P 500 options said that many of the concerns were based on a misunderstanding of how they were being traded, and said “if anything the added volume is just more liquidity, which should [make markets] less risky”.

The trader said he had discussed the topic with regulators, and believed they “are pretty on top of what the story is and are seeking to understand [the issue], not just knee jerk react”.