Professional traders and algorithms have invaded the fast-twitch options market

(Bloomberg) – While it may look like a rebound from meme-era excess, the 2022 boom in super-short-lived index options is more than a retail phenomenon.

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So say strategists at JPMorgan Chase & Co., including Peng Cheng, whose team studied public trading data and found that retail investors cannot be responsible for the S&P 500 contract explosion that mature within 24 hours, a category known as zero day to expiration, or 0DTE.

The assumption that this particular trading frenzy was the domain of retail day traders was fueled by the prevalence of small trade sizes, typically associated with retail crowds, Peng says. It’s more likely computer-based institutions that break down large orders into small ones to conceal their strategies, he says.

“It is tempting to overestimate retail activity in 0DTE options, given that a large number of small trades are observed,” Cheng wrote in a note to clients on Thursday. However, “due to the proliferation of algo trading, trade size is no longer a good classifier for retail versus institutional.”

According to the team’s estimate, about 5.6% of all such short-term options volume over the past month can be attributed to retail market orders. While this is higher than the average of all options trades in the index, it is obviously not the dominant flow. Moreover, the distribution of trade sizes of 0DTE options is largely identical to that of regular trades.

The research adds empirical evidence to the claim by strategists from firms such as Nomura Securities International Inc. and RBC Capital Markets that institutional investors are driving the recent boom in these fast-triggering, high-trading options trading risk.

During the third quarter, S&P 500 options expiring within one day accounted for more than 40% of total volume, nearly doubling from six months ago, according to data compiled by Goldman Sachs Group Inc.

Some market watchers attributed the rush to the need for defensively positioned fund managers to catch the market rally by buying bullish call options. Others suggest that institutions are flocking to products to manage portfolio risk as intraday reversals have become a feature of the 2022 market.

Whatever the reason, these contracts have seen holders in and out in a flash. Only about 6% of those options were held open to expiration, according to JPMorgan data.

What does this mean for the market? Although not unanimously accepted, one narrative holds that the explosion in options trading is causing derivatives to amplify movements in underlying assets, potentially creating market dislocations.

The group at the center of it all are options brokers, who take the other side of the trade and must buy and sell stocks to maintain a neutral position in the market. The theoretical value of shares needed by market makers to cover the directional exposure resulting from all options activity is known as the delta.

By dividing all 0DTE options trades into five-minute intervals, Cheng and his colleagues then plotted their trade-imitation deltas against the performance of the S&P 500. Briefly, the team found that over the course of the last month, the market impact of these transactions can range from a slowdown of up to 0.6% to an increase of up to 1.1%.

“There is indeed a market impact on the 0DTE delta SPX,” the team wrote.

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Sharon D. Cole