Zero Day Options

 According to CBOE data almost 60% of all SP500 option daily volume now comes from the most extremely speculative and leveraged instrument of them all: Zero Days To Expiration options, or 0DTE for short. While they do have uses for institutions (eg index fund balancing), they are now used mostly as lottery tickets.

Apparently, these have now become very popular with retail “investors” who have piled into them in force during the last few months and are causing large distortions in volatility.

Since options market makers must hedge their intraday exposure on 0DTE, they are forced to buy (or sell) the underlying index or individual stocks, magnifying the intraday moves.

This explains the recent erratic behavior of indexes - they seem to spike or fall off a cliff within seconds.

One more layer of unregulated leverage - what could possibly go wrong…?

Addendum: after writing the above I realized I had seen this before, figuratively speaking. This is the 21st century equivalent of “bucket shops” which were hugely popular with punters in the early part of the previous century. The similarity is really uncanny.. see Reminiscences Of A Stock Operator.

Margin Debt Soars

The amount of margin debt in the US has soared to a new high of $1.13 trillion in September (data: FINRA). Some will say that we should look at it as a percentage of total market cap, and I agree. 

However, I have a different point to make. Look at how fast margin debt has increased in just a few months: up 30% since the beginning of the year and 50% in the last 12 months.  This is an indication of froth created mostly by retail speculators who are piling in to make a quick buck.

Does not look good to me…

Leverage and Risk Transmission Mechanisms

 The Great Debt Crisis of 2008-10 was the result of inordinate leverage created by arcane derivative instruments like debt tranches, Collateralized Mortgage Obligations (CMO), Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS). Some of them were even further leveraged, eg CDO squared and cubed.  The degree of interconnection was extraordinary and once one or two dominoes fell, the result was a disaster.

Fast forward to today. Are there similar leverage and risk transmission mechanisms in place? Yes, there are.

1. Exchange Traded Funds (ETFs): once a tiny portion of markets, they are now very popular with retail investors and speculators alike. The biggest ETFs are index trackers, and they MUST buy or sell to follow the underlying index. There are literally thousands of them, with assets estimated at $11 trillion for the US market alone - that’s a massive 20% of total market cap. To make it worse, a mere 10 companies account for 40% of the entire S&P 500 index, which itself is capitalization weighted. Therefore, a very large percentage of stock owners who MUST follow the index are currently sitting atop an extremely narrow market. The operational market leverage risk is unprecedented. By the way, many of the ETFs are 2x and 3x trackers, using futures and options, so there is even more leverage involved.

2. Algorithmic trading. By definition, algorithmic trading is mechanistic. Create a “formula” and follow it, again and again. A massive 70-80% of all daily trading volume in US equities is now algo based and, more worrisome, some 40-45% of this is retail. Algo is, therefore, another layer of “hands-off, brains out” market participation. Like all algorithmic models, algo trading is optimized to perform well under current conditions and is based on current assumptions. This is strongly reminiscent of the debt “tranching” model which was based on flawed assumptions and precipitated the Great Debt Crisis.  

Put everything together: ETFs, algo and an extremely narrow market. The leverage risk transmission mechanism is, in my opinion, very dangerous and prone to a China Syndrome incident. Can anyone throw a switch to prevent it? Can it be done fast enough to stop a meltdown?

Final word: a market exhibiting the above characteristics can be very easily manipulated.