If you still think that fundamental variables such as earnings results, price/earnings ratios, and future sales prospects determine where the equity markets are going, you are living in Lala land. Today, the flows into the options markets determine the future direction of stocks and indexes. At the pinnacle of this market trend lies the zero-date option.

 

But before we get into that subject, I think an option primer is in order.  For those who don't know, options give traders the right to buy or sell a particular stock or index at a specific price by a stated date. Leverage is involved, since one contract allows you to control 100 shares of a stock at a fraction of the price one would normally need to buy a similar number of shares. Instead of committing $13,500 to buy 100 shares of Alphabet, for example, the buyer of the option can control the gains (or losses) of that block of stock for a few hundred dollars. But you don't get to keep this option contract forever. The length of time a contract is in force varies. Some contracts go out for several years, but the more common options are in terms of months, weeks, and now, days.

 

The longer the contract, the more one pays. This premium is in addition to the price of risk or volatility the seller demands, granting you the contract since some stocks and indexes are riskier than others. In the old days, if I placed a bullish bet on the price of a stock that I expected would go up in price over the next few months, I could make several times my money. If on the other hand, the stock went down or simply did nothing, I would lose all my investment. In short, I am betting the price goes up (a call contract) or a bet that the stock will decline (a put contract).

 

Over the last 50 years, options trading has grown in influence until today it rivals the stock market in importance. Some say options have become the tail that wags the dog. While the popularity of options has increased, the trend toward shortening the length of time of option contracts has also grown. But it wasn't until COVID-19 that traders’ appetites for taking large risks came to the forefront. The sharp decline of the stock market over a short period during the initial phase of the pandemic set the stage. The government's response, which triggered a huge spike upward in financial markets, brought in an entirely new generation of market participants.

 

An influx of retail, stay-at-home traders sparked a desire for big risks and big returns. It was the era of meme stocks, of supply chain shocks, inflation, Fed interest rate increases, and AI. Over the last three years, all of these developments made trading 'events' such as macroeconomic data or Fed meetings a popular blood sport. Enter the idea of ODTE. 

 

ODTE is an acronym for zero-days-to-expiration options. Professional proprietary traders that normally hold billions of dollars in equities needed to hedge their risk around one day economic events such as a data release or monetary policy meeting. Traders used ODTE options to protect their stock positions against adverse moves in the overall markets.

 

An announcement by the Fed to hike interest rates could send the stock market down 2 percent in one day. A bad inflation number could do the same thing. This week's date release of the Consumer Price Index on Tuesday, the Producer Price Index, and the Fed's FOMC meeting on Wednesday would be examples of these one-off events.

 

Over time, that strategy worked so well that more and more traders decided that what worked for one-day events could work every day for everything from stocks to bonds to indexes and even commodities. Institutional investors, including hedge funds and asset managers, moved into certain indexes like the SPX (S&P 500 Index futures). As a result, ODTE accounted for more than 43 percent of SPX's daily volume in the first half of the year, according to the CBOE. After the FOMC meeting on Wednesday, for example, $3 trillion worth of the SPX traded in a few hours.

 

It didn't take long before retail traders followed the big boys into this ODTE arena. As a result, by the end of October 2023, the market share of option contracts expiring in less than five days was 59 percent, according to SpotGamma, which monitors and publishes metrics of the options market.

Buy-and-hold strategies, despite their long-term track record of success, have become passé among many millennials. Betting on whether the price of a stock will go up or down before the close of each day has nothing to do with investing. It creates an atmosphere where all stocks become meme stocks. It is the reason why some companies that announce dismal earnings in the morning and drop 15 percent at the open can be up by 5 percent by the end of the day.

 

Some critics claim that ODTE options cause needless volatility in the markets and among stocks. Overall, if daily volumes are evenly balanced between those who are buying and those who are selling these options then the impact on the overall market is somewhat benign. It is when everyone decides to move to one side of the boat at one time that problems could occur. JP Morgan earlier this year argued that under certain circumstances ODTE options could turn a 5 percent intraday market decline into a 25 percent rout.

 

Regardless of the risks, more and more brokers are jumping into this market attracted by the order flow and fees it offers. As such, it appears that the chances of volatility accidents should rise over time. One thing is for sure, the days when one could feel confident that investing in quality companies would be reflected in the price of their stocks is disappearing. 

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.