Wednesday, June 7, 2023

"Zero-Day Options: The risks and returns of selling lottery tickets"

important note upfront: we are not recommending that anyone other than a CBOE (Happy 50th birthday) member enter into the business of writing options. 

Additionally, whether one is a buyer or seller you should have the skill or computers to be able to calculate the odds the house is giving or taking and the optimal bet sizing to accelerate the accumulation of loot while minimizing the risk of gamblers ruin (the Kelly Criterion, see after the jump).

From Verdad Advisers, June 5:

About a year ago, the Chicago Board of Options Exchange implemented a noteworthy change to the options market: they began offering index options on the S&P 500 that would expire every trading day. Traders had long had a fascination with “zero days to expiration” options (aka 0DTEs) but, until this change, investors had to just buy longer-dated options on the day they happened to expire. However, the progressive march of financial innovation now empowers investors to express a view on intraday realized volatility every day of the week.

Trading these ultra-short-term options is fun, and this newfound accessibility predictably led to an explosion in 0DTE index options trading, as the volume chart below shows.

Figure 1: Short-Dated SPX Volume as a % of Total Volume

Source: RIA Advice

On the notorious WallStreetBets subreddit, retail gamblers share screenshots of explosive 0DTE trades, typically long volatility positions that blew out.

Figure 2: A Representative WSB Post
Source: Reddit

The potential for massive gains with a clearly defined maximum loss is psychologically appealing, as is the ability to construct a trade that is indifferent to the direction of the market move. Just think, for a modest payment of $2.00 per contract, an investor can fantasize about 10x-ing his money if the index moves 5% in the next 8 hours. All he must wager is that something will happen, and the internet is happy to provide an endless list of potential “somethings” to keep the punters engaged.

The expansion of 0DTE trading has been likened to an explosion in demand for lottery tickets, and the evidence thus far shows that retail investors are losing substantial sums buying these products. A recent paper by researchers at the University of Münster found that, since May 2022, retail investors have lost a total of $358,000 per day—$90M annually—trading 0DTE options and that they are, as a group, substantially skewed toward long volatility.

Now, the inverse of a stupid trading strategy is not necessarily an intelligent trading strategy. Most bad strategies are bad because they take on uncompensated risk and incur substantial transaction costs. These properties are preserved when one flips the sign on the trades.  But we think that a (small) allocation to short 0DTEs does make sense for many portfolios. We believe 0DTEs are typically overpriced, even after accounting for risk and transaction costs, and that selling these lottery tickets can be a profitable strategy, presuming the allocation to this strategy is kept sized small as appropriate given the high risk.

Selling ODTEs has a very different risk profile to traditional long-only investing because, with options, you can lose more than everything. If you allocate 5% of your portfolio to shorting something that returns 20x one day every 10 years, you will go bankrupt every 10 years. If you allocate 5bps to that same strategy, then once every 10 years you will have an annoyingly bad day where you eat an unexpected 1% loss.

To determine the optimal sizing of this type of strategy, we assume that we want to lose no more than 2% if SPX moves 10% open to close, something that has not happened in the last 30 years. We believe investors could earn 1.6% per year on a portfolio by only allocating 16bps to shorting the 0DTE straddle (assuming a 15% implied volatility, a 14.25% fair volatility, and using a standard Black-Scholes model. These assumptions are justified in a technical appendix that follows this piece). Under these assumptions, selling 0DTE straddles ought to realize an expected Sharpe Ratio between 0.85 and 1.4. This is an attractive Sharpe on its own terms, never mind for a strategy which is at least locally uncorrelated with the broader market. Simulated performance of such a strategy over 10 years is shown below, although readers should bear in mind that this is only one simulated path of many and that real-world tails are fatter than those commonly assumed in options theory....


We put some links that may be of interest in November 2022's "Prudent Bet Sizing And The Best Quote About FTX, Bankman-Fried and Caroline Ellison (to date)"

So How Did Thales Price The World's First (known) Call Options? 

Also, if interested a quick divertissement