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Today’s selloff and why this may be the most important email I send all year

Aug 18, 2023

Good morning! 👋

Goldman Sachs says that Zero-Day Options are fueling the recent S&P 500 selloff.

Are they right?


I’ll take it a step further, though.

Zero-Day Options have destroyed price discovery, made market manipulation easier, and should be banned immediately to protect individual retail investors.

Here’s the skinny.

Zero-Day Options are exactly what they sound like… options tied to the S&P 500 that have a maturity of less than 24 hours. Hence “Zero Days to Expiration,” or “0DTE” in Wall Street speak.

Professionals argue that 0DTE Options are a tactical alternative to trading equity futures because they allow traders to capitalize on positions quickly while limiting the amount of money needed to do it.

Retail investors love the idea that they can place highly leveraged bets on very sensitive options with no overnight margin risk because they expire at the end of day.

They’re both right.

What I have a problem with is the way Wall Street is rigging the game at the expense of individual investors, most of whom are totally unaware that they’re being played like a $2 fiddle.

Zero-Day Options are binary, meaning you win or you lose, depending on where the underlying security settles. They are no different than betting “red” or “black” at the roulette table.

Standard Black-Scholes pricing models used for normal options calculations don’t apply. Trying to hedge ‘em or use more sophisticated position control is nucking futs, despite what legions of erstwhile furus would have you think.

The only way to price 0DTE Options and calculate the corresponding probabilities properly is to understand how price moves and by how much it moves when it does.

If the probability of a move higher or lower is p and magnitude of the move is m, the anticipated fair value of a binary 0DTE Option should be p*m.

Here’s where Wall Street has the upper hand and, unfortunately, the game gets downright nasty.

0DTE Options introduce noise into the system where there otherwise isn’t any. Practically speaking, they’re like handing out firecrackers at a party, then telling everybody with matches to be quiet.

Wall Street’s big money traders and market makers live and die by “hedge ratio,” which is best described as how much of a given stock or security you’ve got to buy or sell, depending on where the price of that stock is related to the strike of the option—meaning, is it higher or lower than the strike.

Very simplistically for purposes of our discussion, this is equal to the probability of finishing ITM or “in the money.” The trick is that the number—the hedge ratio—shifts violently at the strike, particularly as the end of each trading session approaches.

If you’re hedging calls, you need 100% of the underlying security on hand if the price closes higher than the strike. So you’ve got to buy and, often, very quickly. You don’t need anything if it’s lower than the strike and closes underneath the strike. If you’re trading puts, that’s reversed.

Experienced options traders will recognize this as “infinite” gamma because the delta can go from nothing to 100%, even with a minuscule move.

If you’re not an options trader, here’s what you need to know.

Gamma and delta are options “Greeks”—a set of mathematical measures used to measure the sensitivity and risk of options positions to changes in underlying market factors, including asset prices, time to expiration, volatility, and interest rates.

Delta measures the rate of change in an option’s price in relation to changes in price of the underlying asset. It’s usually expressed as how much an option’s price will change for every $1 change in the underlying asset’s price.

Gamma measures the rate of change of an option’s delta. Functionally speaking, it represents how sensitive an option’s value is to changes in the price of the underlying security, which, for the purpose of our discussion today, is the S&P 500. Gamma is highest “at the money” and decreases as options move farther in or out of the money.

The reason this is a problem is because Wall Street’s big money traders have figured out that if there is enough buying activity in specific options—either puts or calls—”buying” the hedge can effectively move the option toward the strike while overwhelming demand for otherwise normal market liquidity.

In other words, they’ve figured out how to move prices practically at will by creating enough “demand” in the options chain because they know market makers and other traders will be required to keep up, meaning buy or sell shares to maintain an appropriate hedge ratio.

Put options are particularly thorny because huge demand from put buyers will generate increased shorting activity in the underlying security. That then forces more selling and creates a negative feedback loop in terms of sentiment.

Technically speaking, what’s happening is actually considered a positive feedback loop because prices move away from their equilibrium, but that’s a hair not worth splitting at the moment. Euphemistically, selling is considered a “negative” in the minds of most people.

The situation reminds me very much of Black Monday in 1987 when computerized trading—then in its infancy—executed larger and larger sell orders in an effort to keep pace with price drops that grew more intense as the feedback loop formed. Ironically, the very computers that were placing huge orders in an effort to limit losses actually wound up magnifying the selloff and accelerating the decline.

I have never forgotten what it felt like when panic took over the exchanges. But that’s a story for another time.

I recall a similar transition when the CME first introduced S&P 500 e-minis in 1997 and were billed as a way to allow traders to speculate or hedge the S&P 500 Index without having to trade the much larger, full-sized S&P 500 contracts. Then, as now, the smaller contracts were also touted as a way to make ‘em more accessible to individual investors and traders.

Big traders figured out very quickly that they could manipulate prices by “hedging” and speculating in those same contracts. Effectively, driving gamma.

You’d think regulators would learn, but Wall Street doesn’t work that way. Changes are viewed as “modernizing” markets and carefully protected as such by vested interests.

What’s happening now is NOT a coincidence.

I believe that there is an excellent case to be made that Wall Street’s biggest, most sophisticated traders are once again—and very deliberately—manipulating the system at the expense of individual investors who, unbeknownst to them, are playing right into the traders’ hands.

Nomura Securities International recently compiled data showing that 1.86 million 0DTE Options contracts—or roughly 55% of the S&P 500’s total volume—changed hands on Thursday, August 10, when the S&P 500 shot higher, only to close sharply lower. That figure was routinely 10% or less as recently as 2019.


That wouldn’t be so bad if it were an isolated incident.

But it’s not.

Nomura’s data also show that 4 of the top 10 most-traded 0DTE sessions have happened this month, just halfway through August.

The news headlines and legions of well-intentioned but clueless economists and market watchers are describing what’s happening as the summer doldrums or relating price action to Fed-related fears. I’ve got a bridge to sell you if you believe that.

The data very clearly show that 0DTE Options are changing market behaviour.

What’s more, they’re changing market direction.

S&P 500 Futures have wiped clean session gains of at least 0.9% several times in the past few weeks alone, effectively breaking the rally that has been in play since last October.

You’re not imagining things if you’ve ever wondered why intra-day volatility continues to climb, the indices seem to reverse more violently, and the markets seem drawn to specific price points.

The average S&P 500 high-low swing ratio was just 1.6 from January to July but has now jumped to 2.2X its daily move on a closing basis this month.

Citigroup’s head of equity trading believes that traders are also using low-cost 0DTE Options to position around key economic data report releases like, for example, monthly payroll and CPI readings on August 4 and 10, respectively.

I agree.

Moreover, the situation is so predictable that you can tell who controls which side of the tape based on where the open interest is stacking up.

For instance, 0DTE calls have generally outnumbered puts since last October, which effectively “pulled” the S&P 500 higher. However, 0DTE puts have dominated options flow since late July this summer, effectively pushing markets lower.

Now what?

Puts dominated the tape again Thursday.

The largest block sat at 4350 as I prepared the first draft of this article late Thursday evening, which is why I am not surprised to see pre-market S&P 500 futures falling to 4355 as I type ahead of the opening.

Both are roughly in line with the longer-term support levels I highlighted late in the day during an appearance on Making Money with Charles Payne yesterday. (Watch)

Traders I’m familiar with suggested yesterday that dealers may have been -$58B short for every 1% SPX move. My quick back-of-the-envelope math this morning makes me think the figure is probably closer to -$60B short this morning as prices get “pulled” lower.


What’s Next

I’ve been tracking related changes in liquidity for our consulting clients for the past few weeks, and what I see is actually good news.

There’s still plenty of money on the move.

Yes, it’s undeniably scary, volatile and downright uncomfortable, but—and this is vitally important to understand—what’s happening now does NOT disturb the longer-term business case for owning stock in the world’s best companies.

It’s purely technical, short-term price action, nothing more.

What to Do Right Now

If you’re a trader, putskies or bearish spreads are your play as long as the 0DTE crowd is playing to the put side. Index options, in particular.

If you’re an investor, now’s the time to do three things:

  1. Harvest gains, which hopefully you’ve been doing all along with the FreeTrades I have repeatedly encouraged members of the One Bar Ahead® Family to take.
  2. Continue to DCA/VCA into low-beta stocks, particularly those with dividends, which I have also repeatedly identified for the One Bar Ahead® Family.
  3. Up your hedges. I will have a special update for the One Bar Ahead® Family later today if conditions warrant, certainly not later than Monday. So please keep an eye on your email. Upgrade to Paid

And if you’re a regulator, please do something about this before it really gets out of hand… like outlawing daily 0DTE Options entirely… while there’s still time.

In closing, stuff like this sounds a lot scarier than it is.

Take a deep breath.

We’ve seen this playbook before, and we know what’s needed to win.

Remember, chaos creates opportunity.

You got this!


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