Add Zero DTE Options and the VIX to the List of Things That Really Don't Mix
Jul 7, 2023
To understand the relationship between the VIX and zero DTE options, you should first understand each of the two independently.
The VIX, a market-based volatility gauge, measures the magnitude of potential price movements in the S&P 500 index. A higher value for the VIX means the market is expecting bigger price fluctuations, and a lower value for the VIX means the market is expecting smaller price fluctuations.
Zero DTE options, as the name implies, are simply options that carry a same-day expiration. So regardless of what might happen that day, any and all zero DTE options expire at 4 p.m. on the close of that trading day.
OK, easy enough … but how is it that zero DTE options are connected to (or not connected to) the VIX?
So, as many traders have noticed over the first half of 2023, market volatility as measured by the VIX has seemed disconnected from what we’re seeing in terms of market movement. Case in point: We’ve had many pretty whippy days with lots of back and forth, or even some decent little down moves, only to look up and see the VIX unchanged on the day, or up a little or, in some cases, even down?
Well, the reason for the disconnect is twofold:
First, the VIX model itself isn’t equipped for zero DTE options. Second, the dealer response to zero DTE options doesn’t have anything to do with the VIX but could certainly explain intraday moves.
So, let’s first examine the VIX equation.
If you look closely at the times to expiration used to compute the VIX, you’ll see that it deals with only two expiration cycles: the near term and the next term. Very much like a front-month, back-month relationship, the near term and next term are using the two expiration cycles closest to the 30-day marker. The near term might be 25 DTE, and the next term might be 32 DTE. Or the near term might be 28 DTE, and the next term 35 DTE, and so on.
In other words, nowhere do you see anything even close to a zero DTE option—not even close. Thus, the VIX is disconnected from zero DTE options.
But second, whenever a retailer trader places an options trade, there is always a counterparty—i.e. a market maker or liquidity provider. That counterparty isn’t interested in taking directional risks in the market—their entire business model is to buy bids, sell offers and collect the spread between the two. So, if a lot of one-sided volume comes in, then these market makers respond by using the stock itself to hedge their directional exposure.
Suppose, for example, traders are really excited about QQQ, and the futures market has the Nasdaq gapping up on the open. Well, right after that open, let’s suppose a bunch of traders buy zero DTE QQQ Calls. Well, the counterparty is on the other side selling these calls, a position that leaves them with short delta (or a bearish position).
To then neutralize this bearish exposure, the simplest move the counterparty could make would be to buy QQQ stock (similar to what happens in a Gamma Squeeze), leaving that original bearish position now hedged. But what happened because of those QQQ purchases by the counterparty? QQQ went even higher, turning a modest move into a much larger move.
And then what happens when all of this is unwound? Do the zero DTE call buyers cash in their profits? The counterparty no longer has a need for the long shares to hedge, so those sells are sold in the market, potentially causing sizable reversal in price and, voila, you have big intraday swings, and you didn’t even touch the VIX.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading and applies it to a trading portfolio. @jschultzf3For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.
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