On October 12, 1987, a week before Black Monday, the Wall Street Journal warned of the potential for market instability. Per the article: The use of portfolio insurance "could snowball into a stunning rout for stocks."
I am increasingly alarmed that a trading tool similar to portfolio insurance will set markets up for a stunning display of market instability.
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Despite the potential to foster market instability, 0DTE is a term few investors have heard of.
Zero days to options expiration(0DTEs) are puts and calls on individual stocks and indexes that expire within 24 hours. 0DTE options may seem like speculative you only live once (YOLO) bets at first glance. But, when one appreciates how brokers hedge options, they then grasp the potential for considerable instability in individual stocks and the market.
Before exploring 0DTE options, it's worth briefly discussing portfolio insurance's role in Black Monday 1987.
Portfolio insurance in 1987
One of my first reactions to hearing of the recent popularity of 0DTE trades was to recall Black Monday and the 22.6% crash of the Dow Jones Industrial Average on October 19, 1987. There were several causes for the crash, but the factor that significantly amplified the decline was portfolio insurance.
At the time, institutional investors were buying portfolio insurance from Wall Street brokers to protect against losses. During market declines, the brokers' computer algorithms would automatically sell S&P 500 futures contracts short. As the market sold off further, the algorithms would sell more contracts.
As the programs sold, they pushed markets lower, necessitating more portfolio insurance-related selling. Selling begat selling, and a correction turned into an avalanche of panic.
The following quote is from a Wall Street Journal article rehashing the crash:
The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time. They pushed stock prices into free fall and individual investors under the bus.
0DTE options
The popularity of 0DTE options is rising precipitously. As the graph below shows, half of the volume of options on S&P 500 futures are 0DTE. That dwarfs the 5-10% share before the pandemic.
Individual and institutional investors are using options that have a very short time until expiry for speculative and hedging purposes. It is also likely investors may be using 0DTE options to manipulate markets. Regardless of the drivers, 0DTE options are similar to portfolio insurance; they can significantly intensify market moves.
To reiterate the WSJ quote: "The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time."
Sound familiar?
Read the full article here by Michael Lebowitz, Advisor Perspectives.
