WTF is “Gammageddon”?  What do 0DTE options have to do with it?  Should I be fearful? Should I be greedy? We’re getting into all of it in this episode where we dig into just what zero days to expiry (0DTE) options are, who’s trading these things, who’s on the other side, and why (and why not) any of it could matter to investors… to option traders…..to the VIX.  On the latest episode of Derivative, Jeff talks with Mike Green @profplum99 and Craig Peterson @t1alpha about what is really happening down in the options weeds as the industry’s newest product makes headlines.

 

During the discussion, the trio covers a range of topics, including why quarterly options may be better than annual, weekly better than quarterly, and of course, daily better than weekly. They talk the decay of options, the participation of retail investors, the ins and outs of gamma hedging, and the similarities between selling calls and selling puts. They also explore the dynamics of gamma explosions and risks involved in trading something which expires before it clears (WTF indeed). So, sit back, relax, and tune in to WTF! GAMMAGEDDON? — SEND IT.

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From this episode:

Charts in order during the episode

tier1alpha.com

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Previous Derivative episodes with Mike Green:

Straddles, SVXY, and (GAMMA) Scalping with Logica’s Mike Green

Hedge Funds vs ETFs, Passive vs Active, 70s Inflation vs now, & Commodities vs CTAs with Simplify’s Mike Green

The Volvengers: Wayne Himelsein (Iron Man) & Mike Green (Captain America) on the Derivative

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Check out the complete Transcript from this week’s podcast below:

WTF?! Will 0DTE Cause Gammageddon? With Mike Green and Craig Peterson

Jeff Malec  00:07

Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go analyze the strategies of unique hedge fund managers and chat with interesting guests from across the investment world. Hello there. Welcome back. Welcome old new welcome red and blue. Welcome to zero DTE traders and welcome to trend followers will be excited to hear we have Marty Bergen president of done capital on next week to talk about four decades or so of trend following by that program. Go subscribe so you get it as soon as it drops under this week where we ask what in the actual F is all the hubbub about with zero DTE options? I’ll admit I was a little bit on the side of it’s just noise. It’s no big deal. But had my eyes open a bit on this pod with friend of the pod Mike Green. And tier one alpha is Greg Peterson who came with data and graphs showing it’s not just the Euro DTE is growing. It’s that everything else is shrinking. What send it This episode is brought to you by RC NS outsource trading desk. We know that our sim does the clearing and execution for several ETFs and mutual funds utilizing futures options and VIX, yeah, check it out at our cmos.com Now back to the show. Welcome, we’ve got Mike Green here. And of course I’m gonna forget Craig’s last name as I’m interviewing Greg. What’s the last name? Pearson Peterson with an E that’s right from when I was emailing you. So like green of simplify Craig Peterson of T one alpha t one alpha or tier one Alpha.

 

Craig Peterson  01:46

One alpha, we we go buy both? Go buy

 

Jeff Malec  01:49

both. So I think our listeners know Mike pretty well. Done a few podcasts, we’ll put those in the show notes. But Greg, why don’t you give us a quick little intro of yourself and what you’re doing at tier one Alpha?

 

Craig Peterson  02:01

Yeah, so as mentioned, my name is Greg Peterson. I’m the CEO of tier one alpha. And I parted up with Mike about a year ago. And we had a shared interest in a lot of these flows models, specifically in the option space. So since then, we’ve started a daily newsletter that we put out talking about options market breath flows. And yeah, that’s, that’s kind of the quick story there.

 

Jeff Malec  02:28

Yeah. And for anyone who hasn’t checked it out, the give us the URL T one alpha.com.

 

Craig Peterson  02:33

It’s www dot tear one alpha.com.

 

Jeff Malec  02:36

Do you run out the.com? Like, yeah, sign up, I think I have a subscription. We were just talking before we started that I haven’t quite used it as much as I’d like. But when I first logged in, and I was banging around the tools, it’s pretty cool stuff.

 

Mike Green  02:48

So one of the key things that we’ve done, and I’m sorry, this is Mike Green, interject I know, this is probably you know, audio for a lot of people. But one of the things that we’ve done in the last year is moved the emphasis away from an app based tool that can be used, although that will ultimately be available to institutional users. And really turn it into a letter that’s capable of going out that allows me to actually process a lot of the stuff that I’m looking at from a daily basis in terms of positioning, particularly as it relates to short term option phenomenon. And, you know, that basically is is, you know, the synthesis that Craig or I are pulling together that’s allowed us to very quickly expand it without dramatically having to expand the expense associated with it, because running these things as hard running it on an app basis, where you have to constantly maintain both the software and the data is actually really challenging. So we’re in the process of figuring out ways to make that economic. But in the meantime, there’s a newsletter that goes out that would encourage people to take a look at.

 

Jeff Malec  03:47

I love it. So that’s for people like me, like, don’t make me go into the tool and bang around and try and find the info I need. Here it is summarize, here’s what’s important today from the data we’re seeing

 

Mike Green  03:57

that Yes, exactly. So the learning curve on all these things is you know, anyone who’s who’s switched over to a Bloomberg or anything else, the learning curve on these things is really steep. And often for the person who’s just trying to get some information, you’re much better served by having other people do that analysis first.

 

Jeff Malec  04:13

So yeah, I think we’ll, as we go throughout, we’ll touch on some of that analysis that you’ve been seeing with the tool, but I’m, so we buried the lead, we’re here to talk about zero d t e options. What the f you guys look like polite, Midwestern types to me, so I’m not going to use the actual word. But what the eff is going on with these things. It’s in the news. It’s everywhere. Half the managers I talked to say it’s no big deal. Half say could be the next ball mageddon I like the new term game again, and too little more fun. So before we dive into all the pros, cons, what’s going on? Let’s do a little fact searching mission here first and kind of level set of exactly what these are and what’s going on. So when did they start? Let’s start there.

 

Mike Green  04:58

So we’ve always had Add zero data expiry options, right any option that is approaching its last trading day is by definition a zero day to expiry option. Historically, options were available initially on a quarterly basis on indices and individual stocks, then they became available on a monthly basis. And then as we move to weekly if you just think mechanically about what happens, you know, the monthly and the quarterly have the same expiry date moving to weekly dramatically increase the number of options that were expiring that same day, all right, seeing high trading levels around those options, the CBOE the Chicago Board of Options Exchange, introduced or began to explore the idea of introducing daily expiry options in I believe it was 21 that they went for initial commentary and then in I believe it was Craig, correct me if I’m wrong, I think was April of 22, that they introduced daily expiry options on indices. There’s really nothing yet available on individual stocks. And we’re starting to see the number of indices that zero data expiry options are available expand. Due to the obvious demand, right, these have now moved from one to say around five to 10% of average daily volume. Obviously, contingent upon you know, that’s not really saying much given that an option has 22 days of expiry on a monthly basis, so you would expect them to be around 5%. Normally, they’ve now exploded to somewhere between 40 and 50%. On any given day of the option trading activity, the volumes are actually tied to the options with zero day to expiry.

 

Jeff Malec  06:37

So what does that look like? But the overall volumes have remained the same? Or is that all been added to so the

 

Mike Green  06:43

volumes have grown. And actually, Craig may have a chart that he can pull up and show this but you know that what we’ve seen is initially the volumes grew a lot. And now we’re seeing an increasing level of replacement of longer dated options. Effectively, there’s two separate dynamics that are going in. One is that strategies that sell volatility sell options have recognized that since that is a high probability trade, you want to do it as many times as you possibly can. Alright, so any strategy like a quarterly call overriding strategy is probably better done at a monthly level, a monthly call overriding skirt schedule is probably done better at a weekly basis, a weekly call roll call overriding Saturday, you see where I’m going with this on a daily basis, right. And so that’s actually where we’re seeing the majority of the actual, quote unquote demand for these products is for selling these options on a daily basis, they’re doing it in smaller size than they would for a monthly option or a quarterly option. But it allows them to do the trade over and over and over again, since it’s a high probability event, it ends up creating a higher Sharpe ratio or win ratio overall, right? Any any given month, it’s, you know, 5050, basically are we going to outperform, but if you continually repeat a process that is slightly better than 5050, it’s actually more like 80% probability, you’re going to end up with super high Sharpe ratio assets.

 

Jeff Malec  08:09

Which, to me, that’s like okay, I’m just have added way more chambers to the Russian Roulette gun, right? So is it still is a terminal break even proposition Right? Like you’re still have a or no, because the is the risk less because their daily.

 

Mike Green  08:26

So so if you properly saw as them, the expected return of selling these options is higher if you do it on a daily basis, there’s two reasons for that. One is because options decay exponentially, remember, they’re going from, you know, value to no value by the end of the day, you basically don’t have to worry about how is the market pricing, the implied volatility for the remainder of the contract, etc, things that have historically added variability to those sorts of strategies are removed when you engage in this sort of dynamic. The problem, of course, is that it is much more coin flip like, and therefore you want to reduce the size of each individual trade relative to the notional in your portfolio. You know, in order to properly size this, the challenge, of course, is that we don’t know if people are actually doing that. Right. Like there’s the temptation is always there to go out and push this once it’s really working.

 

Jeff Malec  09:25

And, Craig, if we put you on the spot that were you going to pull up a chart, I made you the co host if you had one? Sorry, go ahead.

 

Craig Peterson  09:33

Yeah, for that particular chart, I might need a moment to pull it up.

 

Jeff Malec  09:38

And then it my brain also goes through like okay, it’s better. Right, monthlies better than quarterly weeklies better than monthly dailies better than week. Why don’t are we gonna go to hourly, we’re gonna go to minutely, is that a word? minutely? Yeah.

 

Mike Green  09:52

Well, certainly, I mean, that’s the theory of complete markets, right is that all securities should be available at every possible moment. The challenge is twofold. One is from a regulatory framework, these options are not actually cleared before they’re expiring. Alright? So in a weird way, when you have t plus three, settlement, etc, you’re actually looking at a scenario in which these options are long dead. By the time somebody actually says okay, by the way, I did this trade and it shows up on my margin reports, my capital reports, etc. Alright, that is something that should always be concerning. Right?

 

Jeff Malec  10:29

Sorry. Okay. But is that part of the demand that like, hey, we can kind of do this trade outside of our normal risk metrics and everything that gets looked at by our, our board, whatever, like, we can kind of do this before it hits the books,

 

Mike Green  10:41

I would have to believe the answer to that is yes, yeah.

 

Jeff Malec  10:45

And then my second thought there did that come from crypto, right. It sounds like SPF of like, hey, we can we can. We don’t need t plus theory. We don’t need all this fancy clearing stuff. We can do it in real time on the blockchain. I don’t know the internet. But I’m wondering if crypto started where you’re saying they’ve always been zero dt. But

 

Mike Green  11:06

yeah, there’s always been zero dt. So I don’t think that that’s particularly important. I think the scale of it has become increasingly important, right. And so the issue is not dissimilar. It, I just want to be very clear that I’m using this as an analogy, not as a direct comparison. But you know, the misrepresentation by Bill weighing of his exposures to his prime brokers is made much easier if products expire before they clear.

 

Jeff Malec  11:35

Right? He was able to do it without this one,

 

Mike Green  11:38

right? Yeah, he did it the old fashioned way he died, right? This, this technically skirts, the rules. And so if there’s if there’s going to be a change, I would expect that this forces elements of faster clearing of trades, or we’re going to find some restrictions placed around it.

 

Jeff Malec  11:57

In terms of nominal size, and that would be backwards looking, though always they’re like, Okay, you’re getting audited. How many of these did you do? What was the nominal at the time?

 

Mike Green  12:06

Yeah, I mean, that’s, you know, again, like from a prime broker standpoint, it’s very tough to monitor these types of exposures. You know, there’s interesting questions of should you have to post collateral upon executing the trade. You know, if you remember, way back in the Dark Ages, when you had to fill out a very complicated form for your brokerage statement for your brokerage account, in order to be able to trade options. Yeah, you had to agree to all sorts of you know, dynamics in terms of you know, what your risk limits were, et cetera. Again, this is really hard to maintain, with strictly, you know, with structures that expire before they clear,

 

Jeff Malec  12:41

I still have a problem with that you, I still can’t, in my 401k, I want to be able to sell puts on some things, right? I want to be able to do and you still can’t do that in a 401k, they won’t let you have level three, access whatever it is. But I digress. Moving on to who is buying these things who’s buying selling actually, as you’re saying, but who’s doing the majority of the selling? I think a lot of the articles are like, Oh, this is going to blow up. This is retail getting in there. But most of the stuff I’ve read is like it’s not retail at all, retail hasn’t even picked up on it much yet. So what are your thoughts on the who?

 

Craig Peterson  13:24

Do you want to take that one? Yeah, sure. So, you know, I think the retail involvement, it’s definitely there. There was a jpm report out a couple of months ago, and I believe they were talking somewhere in the range of like six and 7% of zero duty interest is coming from retail, which isn’t enough capital, while you wouldn’t think it’d be enough capital to drive up the type of volumes that we’ve been seeing. So, you know, I think this is definitely institutional money coming in. And what’s kind of, you know, interesting about this whole conversation around zero day auctions, is I don’t think a lot of people have really been asking, Where has the capital been flowing from? You know, and especially

 

Jeff Malec  14:07

as the capital been flowing from?

 

Craig Peterson  14:09

There you go perfect. Well, you know, if this is this is institutional money, is this going to be fresh capital? Or is this going to be pulling from a different strategy? And in this case, I think, you know, it’s being pulled from contracts further up the chain. And for, you know, further down the expiry line, and, in particular, I think a lot of this capital flow is coming from 30 Day contracts. So what’s interesting about 30 Day contracts, well, those are the ones used to calculate the VIX. So we’ve actually done some work on this. And we’ve modelled this going back to 2018. And this is actually the dynamics that we’re starting to see.

 

Jeff Malec  14:55

So you lost me there for a second. So the dynamics is, so it’s institutional. What’s the normal percent of retail do we know those numbers? So if it’s six to 7% of zero dt, what’s the on all the rest of the volume? Is it 1015? Less?

 

Craig Peterson  15:11

Oh, you know, I don’t actually have those numbers. I’m not exactly sure. I don’t know if Mike, you have some insight on that.

 

Mike Green  15:17

Yeah, no, I mean, the quick answer is, is that it’s probably not all that dissimilar. And we don’t have the firm date on that. There’s ways that there’s ways that you can attempt to isolate that by looking at order size, although that is increasingly less relevant in terms of isolating retail, versus how it’s spent, historically, simply goes will split orders up seamlessly using technology, right? Yeah. So there’s all sorts of you know, this is one of the real challenges. Again, when you go back to something that isn’t cleared before it expires, like the data is just not great, right? We really actually don’t know a lot about this, this is brand new stuff. I loved the description that you gave earlier, I hadn’t heard that phrase, gamma again. But that is actually a very good description of kind of the risk that exists around these. Because if you if you think about a lot of what we talk about a tier one, and we’re certainly far from unique and talking about these dynamics, you know, when you say who’s buying who’s selling, if the vast majority of the activity is selling, that seems impossible, because every buyer has to have a seller, right? The reality associated with options is is that one of the critical innovations that was introduced by the Black Scholes model in 19, in the early 1970s, is the ability to create synthetic options through risk neutral arbitrage, right put call parity, giving you a way to allow a market to be imbalanced if somebody wants an option, I can theoretically synthetically create that through a combination of futures. Right? So just futures, yeah, Delta hedge, right. So if I’ve, if I’ve sold a call option with five Delta, my hedge ratio is going to be 5% of an underlying future, if I sell an option with 25, Delta, I’m going to have, you know, 25% of the future that I want to short against that, for example, right to keep me neutral in the market. And then I’m going to as frequently as I can, economically, and the really good market makers at this point, that’s, you know, in the microseconds that’s measured, you know, will continually Delta hedge my book in order to keep me from having a directional point of view, which they could care less about, right? I mean, I spend time pontificating on that. You may spend time pontificating on that, but I guarantee you that a citadel Market Maker does not care. Alright, the last thing they want is exposure to the market, they want to capture the premium associated with the market making activity,

 

Jeff Malec  17:44

right, they’d rather not move after they sell you that option. Yeah,

 

Mike Green  17:48

exactly correct. So so when we talk about who’s on the other side of it, you know, the easiest way to think about what would happen is, I decided to go into the market, I own the s&p outright and want to increase the income associated with that, by selling options against it, if I were doing a call overriding program on a monthly basis, I might write it against 100% of my notional, right capping my return for the month, but giving me significant income as I go through it. If I move to a daily strategy, I might want to reduce that exposure to say, 20% of my notional so that I get multiple shots on goal, you know, at any point in time, and I’m scaling that up, if I do the math on what that works out to it’s about a 35 to 40% premium by doing it every single day as compared to on a monthly basis, even at the lower notional level, right. So it’s a higher income strategy. It’s got more diversified observations, etc, making it as we talked about a better quote unquote, trade.

 

Jeff Malec  18:49

Right. And we’re talking like a CalPERS, like some big institutional,

 

Mike Green  18:52

any institution could do this. But all the big institutional desks ranging from Canadian pension plans to multi strat hedge funds, are rolling out strategies around these types of dynamics.

 

Jeff Malec  19:04

And the whole idea is like, Hey, I’d love to make 1% on my beta today, right? Like, so if I’m fine capping it at that 1% or whatever the number is, one, two, how far what’s the average distance of the strikes? We know that that data,

 

Mike Green  19:20

you don’t tilt my head? I don’t think we know that. But Craig, on a daily basis with Chairman alpha will report kind of the spread and trading activity. And it seems to be somewhere in the neighborhood of one to 2% on zero or one day to expiry options that are being written on a somewhat continuous basis, that would suggest that they’re collecting less than 1%. But again, you know, if you’re doing it on 20% of your notional and you collect, let’s say, 75 basis points or 100 basis points on any given day, and that adds up really fast in terms of the income exposures and yes, you’re going to lose some, you’re going to get hammered in terms of the individual option that you may have sold But again, remember, you own the underlying the worst case scenario for you as markets go down, the markets go down and you didn’t make enough income to offset the downside risk. Right?

 

Jeff Malec  20:10

Right. And what? So on that side, it’s the CalPERS, multistrike, hedge funds, pod shops, whomever that’s saying, okay, we can earn a little bit of income here, we’ve already got the beta, we’re good. But right, is that ignoring totally the concept of you make most of your money on the big updates, right? If you’re truncating, the right tail essentially, are you.

 

Mike Green  20:34

Again, actually, so stop and stop and think about that dynamic. Because I’ve only written the option against a fraction of my underlying notional that big update is less of an issue for me now, right, I can have 80% participation in that big update, as compared to only participation up to the amount that the option I’ve sold against,

 

Jeff Malec  20:52

right, if you truncate only make 80% of the upside over years and years, what have you done to your overall beta exposure? Right? Have you really hurt yourself your ability to get the compounding and the outlier gains?

 

Mike Green  21:05

Well, just remember, though, that that you’re exposed to that risk already with a call overriding strategy. Yeah. And so on any given day, the risk is actually less of that under these types of strategies. The issue here from my perspective is in many ways, and this is completely consistent with the theory of options and complete markets, right? This is on net a good thing. Right? It is what we would expect to see in a environment in which you know, these sorts of strategies become available, the risks that emerge, or is that exactly what you described it again, mageddon type event, that markets become discontinuous? Right, if an event occurs, that causes markets to fall sharply, the risk now sits not so much with the override, or right, it’s not the institutional trader who’s doing what they’ve always done, but actually doing so now in a way that is, in many ways more responsible, right and reflecting less risk. The bigger issue that we actually are sitting with is actually at the dealer or the exchanges.

 

Jeff Malec  22:14

And but on the gamma get inside, so let’s just explain those dynamics a little bit. So when we’re talking Citadel, Susquehanna, like, who’s on that market maker side, those big, big, you

 

Mike Green  22:26

know, I mean, it’s, and by the way, they are really good at what they do, right? So I just want to be very clear that I’m not, you know, turning around and saying Susquehanna or Citadel or being really irresponsible here. But the the risk that exists, as always, in options is that you can’t actually hedge that exposure. Right. So a an instantaneous gap of of a large quantity, given the vaults of these that are outstanding in the open interest that sits there could create significant risks for the actual exchanges and market makers themselves, setting up conditions that look more like an AIG failure than anything else.

 

Jeff Malec  23:04

And the the mechanism there’s as the markets going down closer to the strike of that zero DTE, the dealers are shorter and shorter, the gammas going higher, right? They’re short gamma in that scenario, right. So so the sell more and more, which creates correct a cascade

 

Mike Green  23:21

that sell more and more exposure. Right. So again, this is less of an issue as it relates to the net selling of calls, etc. But it really does tie to this idea of, you’ve now got instantaneous exposure to a market that requires markets to be liquid, if you’re going to properly hedge it, right? Again, these guys are really good at this. Absolutely no debate that that’s the case. But anytime you’re dealing with options and the hedging dynamics, the real risk that exists is similar to what we saw with XIV. That’s why people have drawn the analogy to XIV, it’s a move of a large enough magnitude that happens basically instantaneously, that causes the market’s ability to execute these trades to break down.

 

Jeff Malec  24:08

And but this is a different concept, right? Because the market maker in this case has to buy that delta hedging back at the end of the debt, or do they? I guess that’s the

 

Mike Green  24:19

that is, but then I’m gonna cascade

 

Jeff Malec  24:21

back up. So it’s alright, so

 

Mike Green  24:23

so let’s just actually walk through exactly what would happen here. So I own the s&p 500 notional of $100. Right, I decided that I’m going to sell zero data expert calls equal to $20 of my exposure, I’m going to do that 1% out of the money, right. The market maker is now long a call. So they are protected if the market goes up, right and they lose money if the market goes down. So what do they have to do they have to sell futures in a Delta hedged equivalent to the call exposure that they have. Alright, that in turn means when I initiate that call option, I sell the call option. The dealer is now selling futures pressuring the market lower. What happens to the value of the call? If the market is pressured lower? It false. Yeah, it goes lower, which now means the US which mean market means market makers start buying back that exposure, causing markets to rebound. This is the pattern that we’re seeing intraday over and over and over again, where markets are transiting multiple times. We actually highlighted this within tier one Alpha. I think it was yesterday or two days ago. You know, we saw the market move five separate times nearly 1% intraday only to close. I think it was correct, correct me if I’m wrong, but 30 basis points lower. Right. So traditional measures of volatility says nothing happened. And yeah, intraday. Man, that’s a crazy amount of territory to cross.

 

 

Jeff Malec  25:56

And even the vol of vol statistics might not capture that, right? Because it’s all intraday.

 

Mike Green  26:02

It’s, it’s really hard to actually force those levels significantly higher than the realized components, right. I mean, imagine a scenario in which I, as a market maker decided to try to raise the price of the implied volatility to those levels. Competition would immediately come in underneath me and under and, you know, undercut me, yeah.

 

Jeff Malec  26:30

And then, and so, Greg, you’d mentioned before, this is doing some weird stuff to the VIX, because that’s the 30 day options are calculated on so I think that some people’s worried worry, especially in some of the circles I’m in of like, Hey, we’re using the VIX as a hedge and the convexity and all this stuff. If that, I guess, is that next property getting removed? Because of this?

 

Craig Peterson  26:54

Yeah. And I think there’s some valid points around is the VIX broke. And that’s been the big conversation. And, you know, I think this, this really all started back in 2020, with COVID. And we saw the VIX spike to, you know, above 80. And since then we’ve seen premiums, those 30 day, SPX contracts stay really elevated, and they really haven’t come back down. So what I think is interesting with this related to zero day auctions, is, as those premiums have gone up, volume at those 30 Day strikes has gone down. At the same time, we’ve been seeing volume increase at the shorter data contracts.

 

Jeff Malec  27:37

And what and what about the prices at those at the shorter dated? Like, what does that even look like? So in your example, Mike of the using Mike’s example, what would I be selling that?

 

Craig Peterson  27:49

Well, let me just kind of frame it like this. So 130 Day contract, there’s about a 20 to one ratio. So 130 Day contract costs about the same as 20 Zero Kiki contracts. So I think there’s, there’s a lot more, you know, potential strategies that you can deploy with the same amount of capital just by moving down the chain through expirations.

 

Mike Green  28:15

And the other the other thing that happens on this point, right, so remember, if even a fraction of these options are moving to hedging the specific event right CPI released today, therefore, I’m going to hedge on a one day to expiry option as compared to a 30 day to expiry option that really doesn’t capture today’s move at all right? Remember what you’re doing with that 30 Day option is you’re capturing events that occur over the next month, right? Craig just shared the chart looking at the option volume by expiry.

 

 

 

Jeff Malec  28:49

And listeners if you’re listening, go over to YouTube. The derivative there you can see all these pretty graphs here.

 

Mike Green  28:57

You can see all the pretty graphs right so so part of what’s being shown here, this is showing the build up of it. I think Craig’s gonna show another chart that shows the absolute level of of the volume that’s occurring a 30 day that is declined is basically people have said wait a second, it’s much more efficient for me to hedge the event that happens tomorrow, right? This demand really exploded around the October CPI released the cause the market to move like 5% Right. It’s been interesting. I’ve actually been a fairly consistent seller myself against those types of prices. Because you’ll see the single day vol respond to that spike into you know, the one day forward vol has in many situations spiked to north of 40. That’s almost impossible to make money on that hedge. Right. And as a result, markets have failed to deliver on that. And in turn, we’re now flipping around and seeing people basically move to one of our colleagues, David Pegler at tier one called you know, comfortably Nam right? The Pink Floyd song basically is taken over the market where people are like, Man, I don’t even know why I bother hedging anything All right. That, you know, that seems to have been the overall takeaway on a lot of this stuff. But the bigger thing that it’s that I would argue that it’s causing is as we deteriorate. And Craig, can you pull up the chart that shows the actual volumes at the 30 day may take you solely fun? Yeah. When, when you think about what’s happening, so here we go, here’s this is the volume use that the expert is in the 30 day calculation. This is a chart I wanted you guys to see. So initially, we were seeing increased volume activity at those levels in the aftermath of COVID. Although they never fully recovered, the high level of implied volatility meant it was less attractive to hedge using volatility than it was prior to COVID. But what we’re seeing now, is this deterioration in volume, they’re effectively that’s the hedging point, we’re now not seeing significant amount of demand for those tails. That in turn causes the VIX to contract because the VIX itself is heavily dependent on those tails. This is what you’ve heard people refer to as the falling skew in the market, that in turn, turns around and shows up in metrics like financial conditions, indices as saying the market is getting much easier, right? financial conditions are loosening. I’m not sure it says that at all. Actually, it’s just telling you that there’s less demand to hedge at the experts that are used in those calculations.

 

Jeff Malec  31:23

But but you also said something in there, there’s less demand overall to hedge because people are comfortably numb. That’s kind of counter to some of the narrative around this of like, Oh, now we everyone’s perfectly hedged with their zero DTE. And everyone’s kind of perfectly hedged. And a hedge market doesn’t fall and all that kind of narrative. Right? It’s

 

Mike Green  31:42

the it’s the overcrowded bar and alpha roll, right? Nobody goes there. It’s too

 

Jeff Malec  31:47

crowded. Right, right, then how did it get? So Greg? This is yeah, this is super interesting chart here. So listener, we’re looking at 30 day. And it’s surprising and 22, right, that it didn’t spike up back to the normal highs when we’re down where we’re down 25% at the lows or whatever.

 

Mike Green  32:07

But it completely failed to work, right? I mean, that was part of the challenge that we experienced this, the elevated level of the VIX going into 22 meant that it was very difficult to hedge properly using options.

 

Jeff Malec  32:21

And now can What can’t you flip this and say, Well, now, that’s all sort of reversed, and the VIX is at a more normal level, and we’ve rebounded a little bit so it’s somewhat back to normal, or you’re seeing in these charts, no, not back to normal.

 

Mike Green  32:35

So I would argue that it’s no not back to normal. But that doesn’t necessarily mean that it’s quote unquote, expensive either, right? The level of the VIX, this shows the average contract price, you can almost reverse engineer this into the level of the VIX itself. You know, north of 20 historically has represented fairly significant fear in the market. If you think about the distribution of equity volatility, it’s a very bimodal distribution, bull markets, you tend to average 12 to 14, bear markets, you tend to average 20 to 25. As a result, the overall average for the VIX is around 1617, which roughly reflects the standard deviation or realized volatility of the s&p Somewhere around 15 16%. Alright, so it’s when we talk about those averages, we’re basically splitting the market into two separate components, you know, what we have seen since 2008. And since 2020, is by and large, a market that is consistently pricing in the high teens to low 20s, much more consistent with a bear market, even when markets were printing all time highs. Right now, with that said, we also have, you know, dynamics of skew dynamics of of realized volatility that are much higher than we saw in say, 2017. Right. I mean, while the realized volatility is that we’re getting in the current environment, I think 10 Day realized falls about 13 and a half right now. If we look at, if we look at those same metrics, under the lead up into vol, mageddon in 2017, we had like four was a fairly common number to realize volatility as a huge supply of vol was going into

 

Jeff Malec  34:18

wasn’t like 70. Some days, I can’t remember the exact number without a 1% move.

 

Mike Green  34:22

Yeah, Craig around. Can you pull up that chart that we posted in today’s in today’s piece, looking at the share of days, because this is one of these fascinating, sort of dynamics?

 

Craig Peterson  34:35

This was actually yeah, give me one second here,

 

Mike Green  34:38

Craig, get you guys wonder why the service is free.

 

 

 

Jeff Malec  34:44

And while you’re doing that, what do you what are your thoughts on what it does to the upside spike component of the vault right? So if we say like in these normal times, or in these kind of without any event, I can see what’s happening like, is it possible that it lower is the ability of those 30 days because that the zero DT lower the ability of the 30 days to spike and thus the big spike?

 

Mike Green  35:07

So the quick answer is, I don’t know, right? Because obviously markets have to be forward looking as compared to backward looking. The real risk that I would suggest that we face though is that when we have the type of dynamic that we’re highlighting, we’re increasingly people are using very short dated options to hedge is that you get a delayed reaction to something and then everyone’s scrambling for it. So Craig is showing the chart right here that’s looking at the share of days based on absolute returns. So just to very quickly orient you, each day, regardless of whether the market goes up or down 25 basis points, we’re treating those as the same. So down 25 basis points is the same as up 25 basis points down 25 to 50, is the same as up 25, to 50, etc. It’s just a way of centering against that distribution, so that we don’t have too much information on an already crowded chart, you’ll notice that the blue line here, which is the less than 25 basis point days, in 2017, we saw something almost completely anomalous, right, we had almost 70% of the days in 2017, in the lead up to vol mageddon where the market just moved less than 25 basis points. Right. This was a key component in my construction of the trade around XIV that led me to realize that the reason we were seeing such low volatility and low correlation was because of the supply of volatility, it effectively become self, you know, a self reinforcing loop. What’s so interesting about what we’re experiencing right now, is that we’re seeing extremely elevated levels of 100 basis point days, right, we’re now into, you know, kind of four months from the lows in October, well, you know, after four months, and we’re still seeing that 100 day moving average of moves plus or minus 100 basis points, much more consistent with levels from major bear markets, like 2000 or 2008, then anything that even looks like the 1970s, for example. Right, right. This is I mean, it’s a very different structure to the market, and to have people feel this complacent in this type of environment or to argue that financial conditions are easing dramatically. Feels very off to me at least. And

 

Jeff Malec  37:26

I could argue that yes, but because it’s so steady at that level is why vols not high, right? Like you’re if you’re moving around in that higher level, but you don’t break out of that level, then volatility kind of by definition is right, if you went down 1% Every day vol would be low.

 

Mike Green  37:43

If you want well, if you went down 1% Every day vol. II somewhere in the neighborhood of 14%. Right? Right, mathematically not that pure, that’s just pure math, right? The that that hits on a really important distinction, which is the difference between variance and involve, right. So you know, when you have a down 4%, or an up 4% day, that has a huge impact in terms of the calculation of realized volatility, variance, etc. Even though it can average out right, those types of spikes are something we really haven’t seen. And that is, again, it goes back to exactly the XIV type dynamics. You know, if you just, if you think about that negative dealer gamma that causes dealers to be forced to hedge in a procyclical fashion, the market goes down, then they have to short more, right, that’s momentarily removed by the zero data, zero data export options, as I was just describing, because it effectively creates a localized gamma positive position against a overall negative position. And, you know, we’ve described it at Tier one is thinking about it almost like a mathematical order of operations, right? Or a to do list from your wife, right? What do you do? First, the things that she says must be done immediately, right? And then you do the next thing, right. So the gamma that’s tied to options that expire that day, basically become the highest priority activities. And so you focus on making sure you protect against those scenarios, much more so than you do the overall picture, at least in terms of the intensity. Perfect, Greg, right.

 

Jeff Malec  39:22

That’s a good way to get fired from Susquehanna like, Oh, I was worried about the 90 day option. So I was dealing with that and forgot about all our exposure at 3pm.

 

Mike Green  39:31

Perfect. So Craig, why don’t you Why don’t you talk to this chart very quickly.

 

Craig Peterson  39:36

Yeah, so essentially, what we’re seeing is applies switch that over. So essentially, what we’re seeing is the shorter, dated contracts. The shorter they are, the closer they’re moving to, you know, what Mike described as this kind of positive gamma pocket. And you have to understand, too, that when we talk about zero day options, a lot of time we’re talking about the volumes and the relative volumes for, you know, out of the total volume. But the open interest is still really packed in the monthly and quarterly expirations. So that’s why you see, you know, when we look at the total framework of SPX options market via the gamma profile is much different for all expirations versus shorter dated ones.

 

Mike Green  40:28

The other the other thing that jumps out of this chart, you’ll notice that the gray line, which is the aggregate exposure, and the blue line, which is the beyond 30 days, highlights another feature that is a residual from 2022, which is people are largely hedging using spreads as compared to outright. Right. So what this what this is telling you is, is the dealers themselves can be exposed to kind of those gaps that we were talking about before. And you see that with the purple line here where there’s that immediate exposure. But in general, the market is under protected against a significant downside move. There’s very few players out there who are saying, My gosh, we could have a crash of 87 type dynamic, right? We heard that over and over and over again in 2022. Oh, my God, the markets are gonna crash. What you’re seeing with this type of exposure is basically nobody’s hedging against that anymore.

 

Jeff Malec  41:24

What? What are your theories how they just, it was?

 

Mike Green  41:29

Right, I mean, you know, there’s only so much pain that people can take before they turn around, they say, okay, you know, let’s, let’s be more cautious about this type of exposure. And again, you know, that’s almost kind of the worst case scenario. It’s not that people are not hedged, because they feel confident. It’s the people are not hedged, because they’re exhausted from spending money on protection, which

 

Jeff Malec  41:53

typically or historically has led to the very need for that protection. Right.

 

Mike Green  41:57

It does tend to have a nice correlation with it. Yes.

 

Jeff Malec  42:01

Yeah. that the timing is the tough part. We should explain GECs here and gamma exposure, right. So we’re saying, as the market rises, the Greg, why don’t you go ahead and explain it in more layman’s terms of what we’re looking at in terms of GECs here.

 

Mike Green  42:24

So when you when you think about the dynamics of ghacks, right, what we’re referring to is gamma expiry exposures. If a dealer going back to Everything we’ve talked about here, if a dealer has sold an option, or if a dealer has purchased an option from a Counterparty on a net basis, because, again, unlike, you know, regular markets, you tend to have an awful lot of imbalance. Everybody wants to hedge Tesla, everybody wants to, you know, bet against the bearish outcome. Everybody wants to override calls. There’s an awful lot of everybody’s that tends to happen in the option space, right? Yeah. So when the dealer takes the other side of that what we’re highlighting here is what their exposures look like to changes in price and the underlying. And so when people are hedging their exposure using put options, the dealer has sold that put option and delta hedged, they’re now exposed, if they’ve sold a put option, their risk is markets go down, they will sell futures in a Delta hedged exposure to that, right. As the market goes lower, those put options move into the money, they move towards Delta. That means the dealers have to sell more, right? If God

 

Jeff Malec  43:36

just Okay, so it’s fair as I’m looking at his chart, all expiries, currently, there’s the deals are short 420 billion in gamma, or they have 420 billion to sell. And then as we move to 3800, strike, they have, like 1.3 billion to sell, right? So that’s that cascading effect of like, as the market goes further and further, they have more and more to sell. What’s interesting here is it, it starts to tick back up. So it’s not a infinite cascade into oblivion. And they at some point, they why does that why does it tick back up,

 

Mike Green  44:08

it remains negative, I just want to be clear on that. But when people have hedged by buying a put spread, for example, then the dealer is short the near the money strike, and long the out of the money strike, which means as the market moves up, or moves further down, they start to gain Delta from that lower strike. So they don’t need to hedge nearly as much. Does that make sense? Yep. And so, if you look at this picture, it literally looks like you know, the payoff structure associated with shorter call spread, sort of put spread.

 

 

Jeff Malec  44:43

Right, and then this also tells me like, this is back on the like, this doesn’t matter. Look at the, the zero de Lyonne there’s not all that much gamma they’re like to move the needle.

 

Mike Green  44:53

Absolutely correct. And this is one of the reasons why, you know, we’ve seen fewer examples of the market kind of Melting up above that 4100 level, you know, just mechanically as the dealers, if I have written calls against my underlying position to the dealers, so the dealers are net buyers. As we move to that point, the dealers themselves basically are now in a delta one situation, they don’t have to worry about chasing it. Right, that creates conditions under which they’re going to end up selling exposure in the market as it moves higher, pushing the market back lower.

 

Jeff Malec  45:28

And what do you say to people or basically, look at all this good stuff, say this is, they probably wouldn’t say garbage. But like, this is noise, you can’t really get the net needed data out of the records. How are you getting this? You’re getting it from the actual prints at the end of every day, right?

 

Mike Green  45:46

Yeah, no. So so first of all, I would agree with them that there’s a lot of noise in this data, right? I just want to be very clear that this is not a you know, a magic solution to how to time markets or anything else. Right.

 

Jeff Malec  45:59

Right. Highlighting is what are put out signals and whatnot based on it. That’s yeah,

 

Mike Green  46:04

and we actually believe that you can do that, right. And there’s pretty good evidence that when you move into a positive dealer regime, that the volatility falls, as you’d expect, when you move into a negative regime, the vol rises, as you’d expect, the zero day to expiry options is basically the markets way of saying, Aha, let’s make it more complicated for you. Right. And that’s, that’s half the fun is that the puzzles are always changing. So having dissected components of this and understanding how it’s work and try it, how it works, and try to figure out what the risks that that creates are. That’s that’s really the fun in this process. What I would suggest is is twofold in response to that. One is that that’s absolutely correct, there’s always going to be far more variables than we can isolate in any one analysis, right. But the second is, is that if you actually believe that these markets are getting thinner and less liquid, and the aggregate supply of liquidity into the system has fallen, in a perfect sense that the importance of these types of activities, this hedging activity, is going to have a larger impact on the market itself. And the evidence for that is is almost incontrovertible at this point.

 

Jeff Malec  47:14

That’s back to your whole passive thesis.

 

 

 

Mike Green  47:18

And it’s certainly part of it. It’s part it’s tied to the changing market structure, right. So we’ve seen everything ranging from the quantity of liquidity that is supplied at any given price has fallen dramatically, that means markets are more likely to move in response to a large order coming through. And hedging certainly qualifies as that, as it’s become more and more concentrated in a limited number of players.

 

Jeff Malec  47:44

Greg, do you guys run this on like Tesla, and on individual names, or no, it’s all index.

 

Craig Peterson  47:50

You know, we can run this on everything. But I have found that the biggest impacts come from SPX. And that’s just by pure size of the options market. So although there is, you know, there is some gamma effects on on single stock options, I think it’s it’s broadly more important to track it at the index level. And I The other aspect of that is when we’re talking about single stock options, is these call overriding programs in it’s a, it’s a little bit, it just makes the data a little bit more noisy. So, you know, to Mike’s point, there, there’s definitely some assumptions in these types of models. But that said, I do think they do a reasonably good job at, you know, working as a proxy for what’s actually happening in the background. And we’ve shown that through our back tests, through looking at realized volatility in different regimes, you know, we see a pretty direct link,

 

Jeff Malec  48:49

and then help me understand because we’re saying, I guess it’s the same, but we’re saying there’s all these vol sellers that are emerging and that’s part of this data. But when I think of of all seller, I think of them selling puts this chart and what we’ve been talking about as they’re mainly selling calls. So they’re short volatility mathematically in both cases, but not the downside volatility, I guess. How do you think about that? You see, most of the selling institutional selling of the zero d t, or all the whole expertise for that matter is mostly call selling.

 

Craig Peterson  49:24

I’m not sure I’m gonna let Mike take a stab at that one.

 

Mike Green  49:28

Yeah, so So the quick answer is over to you. Yeah, you’re exactly. You’re always gonna see more call selling than you’ll see put selling for the fairly obvious reason that you know, if people own the underlying theoretically, it is a less risky trade to try to earn a little bit of additional income by forgoing some additional upside. Remember that you know, put call parity tells you that mechanically though selling calls is writing puts right I am exposing myself to all the downsides. So it’s not really all that different. And that’s one of the things that dealers are actually taking advantage of right, that allows them to say, Wait a second, there’s an excess of demand to sell calls because people feel safer with that sort of exposure. They’ve already accepted the downside in their portfolio. They’re willing to give up some upside. Well, again, that’s it. I mean, mathematically, it’s identical to selling puts, but it doesn’t feel the same.

 

Jeff Malec  50:27

Yeah, right. And then that same concept, can the dealer instead of doing all the gamma hedging and causing that cascade could buy the zero DT putts that they could

 

Mike Green  50:38

but who would they buy them from? Yeah, from them, right. And so that like, again, remember, they’re there to facilitate liquidity in the market not to demand liquidity from the market. The problems emerge when dealers are forced to demand liquidity from the market, which is the type of dynamic you’re talking about with a gamma again, or vol mageddon type component are suddenly the market gaps, and they’re left to scramble and say, Wait a second, I need to hedge. Right, that exposure is the scary one.

 

Jeff Malec  51:11

Our friend said, Francis, so I think you know, he was telling me you guys used to Bloomberg chat a lot. But what he was saying a lot. Yeah, his theory and I’m putting words in his mouth, but he would say like, a lot of this volume could be the hedging with the options themselves. So instead of just a normal, the institutional selling in the market maker, your 234 axing the number of the options volume in the zero d t, because the delta hedging, the gamma hedging is actually on the same, not the same strike, but the same instrument, essentially. And that’s something I was

 

Mike Green  51:49

I had not heard a lot about, again, there’s many reasons why I talked to this incredibly bright guy and his the team that he’s working with are doing great things. So I’m gonna reach out to Zeb, right after this call now.

 

Jeff Malec  52:03

Do it. Yeah. And I could have totally mangled his words there. But it’s interesting. So how does this all end? It doesn’t we just keep zero DTS keep growing into infinity and the CBOE is the largest company in the world.

 

Mike Green  52:23

Well, that would be an interesting outcome, but seems unlikely, right? The argument that I would make is that the Gam again, argument or the volume again, two type argument is ultimately likely to play out. I just think that people have gotten hyperbolic about these options in two forms. One is the idea that this is just retail punting and speculation, it’s not right. These are sophisticated players with a very valid reason to be using the products that they’re using.

 

Jeff Malec  52:55

And what about there’s been talk, it’s institutional punting and speculating.

 

Mike Green  53:00

I again, I think that there’s, you know, hopefully, it’s been clear that there are very valid reasons why you would actually do this as an institution, and do it in a way that actually improves the outcome associated with your strategies. Right. So like, I don’t, I’m not going to immediately jump on this and say, this is craziness, right? What is a little crazy about it, though, is that because it falls into a category of securities that are not clearing before they expire? We actually genuinely don’t know the types of exposures that are being taken on.

 

Jeff Malec  53:35

Right, that that’s the part I hadn’t heard before. That’s a great point.

 

Mike Green  53:38

That’s, that’s, that’s the part that I care about. And I understand that that in turn creates conditions. And this is exactly what happened in the COVID environment. We’re becoming increasingly reliant upon the supply of this daily volatility. If people ended up getting hurt with these strategies, because markets continually cascade for a period of time, or because vol fails to respond in a predictable way versus historical models. We could see people either get blown out of these spaces, or conditions created in which a single large market maker gets hit by an unexpected action. In particular, I would just highlight the risks associated with a discontinuous market event. Heaven forbid tomorrow we walk in China has invaded Taiwan. Joe Biden has, you know, you know, suddenly decided that he doesn’t want to do the job anymore. Who knows what the answer is, right? Yeah. An event occurs that doesn’t matter what it is that causes markets to gap in a meaningful way. That leaves exposure to the you know, the market maker community to those who might have written puts that we’re not aware of because they haven’t cleared properly, and somebody can instantaneously blow up creating a gap in the market, which in turn creates its own fulfilling Type dynamic, right? That’s all I care about on this, I actually don’t think that this is craziness, I could care less whether retail is going in and buying call options or doing all that sort of stuff. But for this to be happening in a much broader environment of reduced liquidity and creating the risk that that is further increased on events

 

Jeff Malec  55:20

in this you know, I hate to say it this way but basically unregulated space. That’s all I care about. And it’s a big sorry just made me think of something went back in the XIV. Do you think people were selling that in the same way instead of selling a call? They would sell XIV

 

Mike Green  55:38

or so? Yeah, so buying XIV. Right? me buying Yeah, yeah. So buying XIV mechanically was selling vol. Right.

 

Jeff Malec