Hot new bad idea

0:06Pushkin. Zero day options. They're growing quickly. They're scaring people. And they expire fast. just like this intro. This is On Hedge, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu here in the New York studio, joined today by volatility vulture, Robin Wigglesworth in Oslo. I thought you were going to call me a volatility vixen or something there. That's better. Vixen. That would have been better. That's a female fox though. So yeah, let's say maven. Maybe that sounds better. The vol maven. Robin, zero day options. Sounds a little wonky, but it tends to be the wonky things that blow up the most dramatically in financial markets.

0:47And these have absolutely exploded. There's no two ways about it. Citi recently published a measure showing in the last 20 days, zero-day options have reached their highest share of US options volume, 49.3%, about half of all volume in options. It's just absolutely huge. There's a European exchange listing these zero-day options next week. They're expanding everywhere. and like anything that's grown quickly in finance, we got to ask the question, is it going to blow up dramatically? That's what we're talking about today. But Robin, maybe we should just start with what the hell are options? Yeah, I mean, it's good to start at first principles and options, you know, they sound funky, but they're basically financial derivatives.

1:27They basically work as a bet on something going up or down. So a call option is a bet on something going up and a put option is a bet on something going down. And they've been around, frankly, for ages, especially people used to buy them to insure against moves in pork bellies or orange juice, for example, trading places. If anyone's watched trading places, what they're trading there are futures, options, and other derivatives. Typically, these options would expire in maybe a year, a quarter, three months, a month, a week. And now, today, we can trade zero-day options, literally options that expire, keel over the die the day you buy them.

2:06Financial innovation. You can buy them at 10 a.m. They close at 4 p.m. Magic. Financial innovation does seem a little bit like magic. These can trade on a single name, Tesla, Apple, whatever, on an index, the S &P 500. It's just like that classic option, but shorter. And I think the appeal kind of lies in the fact that because these zero-day options are so short-dated, they're also really cheap. You can turn a tiny little upfront investment into a really big gain. Of course, the other side of things is that you could easily lose it all, right? That's the difference between an option on the one hand and stocks on the other.

2:42With stocks, it's very rare that you're going to lose everything at least right away. Whereas with an option, that could easily happen. That could happen the day you buy it. It's like a sports bet. Like sometimes you just want to know, you just want to put money on what's going to happen in the match today, not the match in two or three weeks time, right? So if you're a day trader sitting on Reddit and Robinhood, or frankly, a hedge fund bro somewhere sitting in Chicago or Florida, you just want to bet on what a stock is going to do that day. And that kind of is appealing, right? Yeah. Oh, and I'm glad you mentioned the hedge fund bros and the Reddit punters.

3:14I think a natural question to ask is who's in this market? Frustratingly, it's actually kind of hard to tell. The people that have looked at this closely disagree on exactly what the split is. I think we can say there are both everyday investors and institutional funds like hedge funds trading here. But you go on r slash Wall Street bets of 2021 meme stock fame, and you see people posting their gains and losses on zero day options. I mean, I just pulled up this one from July. This guy who took a big bet on Carvana took a$25 ,000 loss and posted on Reddit, I got suckered into the morning pump. The hedge funds and market makers got me.

3:51I walked right into this trap like an idiot. Enjoy the losses and have a great weekend. Point is, there are retail investors out there losing money on this stuff. Yeah. I mean, certain things are just eternal truths in financial markets and retail traders getting their faces ripped off by market makers and hedge funds. That's never going to change. Zero day options is just a very efficient way of doing so in my view. Yes. An efficient way to separate money from the sucker. But that's not the only thing that people are worried about. There's also kind of broader market worries beyond just individual people taking losses.

4:24And there's a recent example of a little bit of drama in a tiny little corner of a derivatives market having way broader impacts across financial markets. And that was the 2018 episode known as Volmageddon. Yeah, it sounds scary. And it was an amazing name. I loved it. But yeah, it was crazy, right? So you suddenly have these small funds that were technically known as inverse volatility funds, but they used derivatives to bet on the stock market remaining calm. And when the stock market wasn't so calm, they suddenly kind of died and kind of took down a large chunk of the stock market with them.

5:00So it wasn't like a financial crisis. Most people can't even remember VIXMageddon or Volmageddon or whatever we want to call it. But these tiny volatility linked funds helped cause carnage on global stock markets. The losses were in the trillions of dollars in a matter of just a few weeks. That's pretty crazy, right? I mean, that these tiny funds snowballed and caused that kind of damage. How big were those funds to begin with? Can you give us just a sense of scale? Two, three billion dollars. Wow. So several orders of magnitude in ultimate impacts. Yeah. And it shows how markets like we have all these crazy feedback loops that can kind of crop up out of nowhere.

5:41And sometimes like small little things like, you know, an options bet can arise. Sometimes typically like a big hedge fund does something really heinously stupid and blows up that can ripple and cause quite a lot of issues elsewhere. Yeah. And I think Volmageddon and what happened there, the mechanics are complicated, but I think broadly speaking, they share some general principles with, you know, what could in theory go wrong with zero day options. And that in general, that when there is some new financial a product out there for you to peruse and purchase. Somebody has to create that product and issue it to you.

6:14But generally, the people that issue these products, they're called market makers, they don't really want to take a bet one way or another. So you might have bought a zero-day option on Tesla, but the guy selling it to you, he's totally neutral on Tesla. So the market makers have to go out into the market and take the inverse action to offset the bet that they've made by selling you a contract, right? So you've got one guy buying a Tesla zero day option. You've got the market maker selling that contract to them, but then the market maker has to go into the market and make an offsetting transaction.

6:46And that's where things can get complicated. If there's a big move in Tesla stock or in Tesla zero day options, then the market maker is in this awkward position where they have to either buy or sell something, not based on what they want to do, but because the market's forcing them into action. And that kind of forced buying or forced selling is what creates these ripple effects. Well, that's exactly it. That, you know, in a weird way, and this gets super complicated, but, you know, zero day options and options in general can actually, it weirdly have a dampening effect on volatility in certain cases up until a point.

7:18It's like a stick that you can bend and it will bend, but if you bend it too much, it'll just snap. And that's when you see maybe, let's say a 1 % drop suddenly becomes a 3 % drop because of these feedback loops. And that's the worry that people have, that these zero-day options volumes have just become so, frankly, gargantuan. It's like this engorged beast that's been feeding on the options world that it is making the market more volatile in the middle of the day and could potentially cause a major stock market upset, let's say. Right. Let's try to put that in context though, Robin. Is a stock market sell-off the end of the world?

8:01I think when people think about big crashes in markets, 2008, 2008. I mean, let's try to put this in perspective for listeners. Where is this on the ranking of worries? If I'm being very honest, pretty low. I worry about a lot of things. It's literally what I always do for a living. It's all you do. Yeah. Yeah, exactly. And I like stuff that goes boom. I mean, I want the zero day options phenomenon to blow up massively because first of all i'm a financial journalist i love writing about big massive accidents in financial markets and i think it's stupid like i'm a liberal luddite like i don't want to ban people from doing dumb stuff but this is dumb there is no real societal value in having zero day options it's just baloney but i i find it hard to really think this is going going to be a major disaster.

8:50Certainly on the long, long, long list of horrible things that can and do always go wrong in financial markets. I think this is one of those things that some people are going to lose money. They're going to have very awkward explanations to their husbands and wives and partners and parents. It's bad and the house wins. Fundamentally, this is good for market makers and hedge funds and investment banks, but it's not going to be something they have congressional hearings about, I think. Last week on the Unhedged Podcast, Robin Wigglesworth took on old people, saying old people are the worst. This week on the Unhedged Podcast, you hear that Reddit day traders, he hopes you'll lose money.

9:25Yeah, I want them to blow up. But I'm a sucker for lost porn as well. And I bear the scars of many losses myself. So I'm speaking from a place of hard-earned experience and wisdom, I hope. Speaking of lost porn, I just want to close out this segment with a reading from the book of Reddit. Lost porn, 1500 SPY, zero date option. Bought today at 1030, sold to close at 1230. Added 100 more contracts to try to average down. F me. This was not house money. This is my savings. Excuse me. I'm going to go throw up again. Boom. We'll be back in a moment with Long Short.

10:14Welcome back. This is Long Short, that part of the show where we go long a thing we love, short a thing we hate. Robin, man, I'm short these Republican primary debates this week. Without Trump, I just feel like it's going to be boring, man. It's all of these people with no shot at winning just trying to knock each other down. And according to the DeSantis strategy memos that the New York Times got the other week, they're not even going to talk about Trump, who is leading the race by a huge margin. I just, I feel like it's going to really be a flop. Yeah, I'm probably like, I'm short in size or political debates, to be honest, but especially American ones, I have to admit.

10:50That's true. They're really not great. Robin, are you long something? I am actually. It's not something you can go long on, but I am from a very emotional standpoint, which is I'm long at the Bloomberg Terminal. The Bloomberg Terminal is basically just this piece of kit that you can rent from Mike Bloomberg, the former New York mayor, that collects all sorts of financial information, data and analytics in one place. And it is unbelievably expensive. It costs like 30 ,000 bucks a year, but it is so amazing and so good that I would quite possibly trade one of the kids, my kids I like the least for a lifetime subscription to one, if I'm being perfectly honest.

11:30Hopefully they won't listen to this, but I love the terminal so much. And people are predicting killers, Bloomberg killers for ages. I just don't think it's going away any time in my lifetime. So I'm long the Bloomberg Terminal. I would also trade one of your kids for Bloomberg Terminal. Yeah, fair. All right, Robin, thanks for being here. We'll have you back very soon. And listeners, we'll be back in your feed on Thursday with another episode of Unhedged. Catch you then.

11:59Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forres. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free. A 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

12:41We'll be right back.