The explosion of risky zero-day options could worsen market shocks, JPMorgan says
JPMorgan is warning about a “Volmageddon 2.0” with the explosion in the use of zero-days-to-expiration options, estimating that these risky contracts could exaggerate declines to as much as 20% during market turmoil.
0DTE options are contracts with a fleeting shelf life, expiring the same day that they’re traded. Daily notional volumes in these 0DTE options that track the S & P 500 recently reached a record above $1 trillion, according to JPMorgan data.
The Wall Street bank conducted an experiment to see the impact of these options during a sudden drop in the broader market. Firstly, the firm tallied the net outstanding positions of all zero-day options at 1 pm E.T.
every day in the first two months of this year (1 pm is the lowest liquidity point during market hours).
Then, they hypothesized a 5% drop in the S & P 500 within five minutes that would force all outstanding 0DTE position to be unwound in the following five minutes.
The bank then estimated the net option delta before and after the hypothetical market shock, taking the difference as the amount of E-mini futures needed to trade to unwind.
Delta is the theoretical estimate of how much an option’s value may change given a $1 move up or down in the underlying security.
JPMorgan concluded that, for market shocks between a 1%-5% loss, the corresponding market impact from these option positions having to be unwound averages to a decline in the range of 4% to 8.1%.
In the worst case scenario, a 5% market decline could lead to up to $30.5 billion of delta selling and a 20% pullback in the broader market.
“The estimated market impacts from 0D option unwind exceed the original market shocks in all scenarios, highlighting the reflexive nature of the 0D options and their potential risk posed to market stability,” JPMorgan said.
The S & P 500 pulled back by 2.6% in February after rallying more than 6% in the prior month. In early March, the broader market index is up by more than 2%. .SPX YTD mountain SPX in 2023 — CNBC’s Michael Bloom contributed reporting.