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As markets become more volatile, a growing number of investors are turning to options. Greg Bonnell speaks with Jimmy Xu, Portfolio Manager at TD Asset Management, about how it works as well as the potential risks for investors and the markets.
Transcript
Greg Bonnell: If you’ve been a bit confused by the price movements of a stock you hold, it may be because of a new option strategy. Short-dated options have become an increasing part of trading volumes. And our featured guest today says it could also mean more vulnerability in the markets. Joining us now for more on this, Jimmy Xu, portfolio manager at TD Asset Management. Jimmy, welcome to the show, and what a fascinating topic.
Jimmy Xu: Thanks for having me here. And it’s been a really interesting year considering what’s happened on interest rates, tightening financial conditions. But it seems like investors are still very happy to trade. And that’s been a theme that has come across and continue to carry through since the pandemic.
Greg Bonnell: And using this kind of option strategy, I want to explain it to the audience because I’ve had a few guests just sort of mention it to me on the slide after shows. I thought, well, that’s pretty interesting. We need to find someone to talk about. They said Jimmy is the guy to talk to about it. So let’s talk what are they? What, zero day short-term options. How do they work?
Jimmy Xu: You know what, these strategies, they’re actually quite clever. Historically, if you go back to prior to the financial crisis, these strategies are being implemented by institutional investors. But the same type of strategies are now being seen– being invested by everyone. These zero-to-date maturity options, the expired options, are basically options that expire the same day, as the name would suggest. So what investors are doing is they are selling options at the start of the day in hopes that when the options expire worthless, as they decay down to zero, they can capture that premium from what they’ve sold.
And it’s really interesting why they’re doing this now is since April and May this year, the CBOE, the US Option Exchange, has put out effectively daily options with daily expiry. So investors can do this every day, day in day out. What they’re trying to capture on is the decay of the options. So when they sell the option in the morning, they collect that premium. And by the end of the day, they hope that it becomes worthless, if they’re right, or buy it back at a lower price. What’s interesting about these strategies, why they’re so popular is they’re very capital-efficient. So only takes– requires margin in the account, which makes them popular. And second, they’re also popular because they don’t have to take overnight risk. They can sleep at night knowing that they’ve closed out the positions by the end of the day.
Greg Bonnell: That’s interesting. We should make clear, though, this is something that’s happening in the markets. We want to discuss it. We’re not making any recommendations about how you should structure your trades. Let’s talk about some of the risks, though, that could be associated with it. Oh, an option that expires in one day, what’s the risk?
Jimmy Xu: There’s a lot of risk involved any time you’re short selling options. And these strategies has, for lack of a better word, blown up historically prior to the great financial crisis. So it’s interesting that we’re seeing a resurgence of this in a period where financial conditions are tightening and volatility is rising. So when investors are implementing these strategies, they’re usually selling options, because they’re short maturity; by definition, they only collect a small amount of premium. However, if market moves the wrong way or moves too much or more than what they expected, losses could be 4, 5, 6, even 10 times the amount of the premiums that they collect. So there’s a lot of risk involved.
But here’s the good thing. When we look at some statistics that talk about these trading strategies, it seems like the hit rates or the positive P&L rates are sometimes more than 50%. And I think there’s a psychological aspect to this, right? So you do this day in, day out, and it turns a small profit every day and you all of a sudden get really confident in the strategy, and maybe you start to increase their size, and maybe you start selling options when it’s not really attractive. And that can get you into a lot of trouble. I think Nicholas Taleb, who wrote his book on Fooled by Randomness, has this great turkey example. It’s like turkey out of turkey farm every day. You’re getting fat. It’s a great life. You call your other turkey buddies to come. And then when Thanksgiving rolls along, the markets move more than what you expected. Lights out.
Greg Bonnell: All right, good words of caution right there. You don’t want to be the turkey on Thanksgiving. So that’s the strategy. Those are the risks around the strategy. How popular is the strategy?
Jimmy Xu: I think what surprised us the most is the popularity of these strategies since these weekly options that were listed earlier this year. So just looking at market stats over the last month, almost 40% of all traded options volumes are these zero-day maturity or expiry options. And that’s quite remarkable. Just to put that in context, that’s $2.4 trillion in notional. Granted that not all of these volumes are related to these trades because people still use same-day maturity options for other activities, but it’s still a large chunk of the market.
And I think it’s popular because now, trading is just getting easier and easier. Retail investors can trade on their mobile app. It takes seconds to do it on their phone. And in the US, commission trade, a commission is free for trading options. So when there’s no explicit transaction costs it just makes these strategies a lot more attractive to the average investor. When you look at the trading volumes, each trade is typically 5 to 10 contracts, which is for the most part too small for institutional investors. So our theory is that these things– these strategies are dominated by retail investors. And I think that’s a trend that we’re seeing post-pandemic where retail volumes are becoming a greater, greater portion of the overall market activities and we’re seeing it in the option space as well.
Greg Bonnell: I would never assume to fully understand why a market is moving in either direction, even after the years that I’ve been doing this. But there have been times this year where I’m like, why is it doing what it’s doing today? It’s like, I don’t know, it’s just doing it. Is this having an impact on some of the wild moves we’ve seen this year?
Jimmy Xu: It’s possible. It’s hard to determine what’s actually causing the wild moves in the market. But we know based on trading activities with these type of investors, they’re selling the options in the morning. And you’re seeing option volumes really pick up in the morning. And that could create a bit of volatility. But most of the fun comes at the end of the day where investors are trying to close off the position, especially if things start to move in an average direction. And what that could cause is more volatility at the end of the day, where investors are trying to close these positions. Just give you an example. If you’re short a put option or markets goes against you, to close that option position, you have to sell more stock, which puts more downward pressure. And that could cause wild swings in the market when you hit pockets of liquidity especially on a year like this.
Greg Bonnell: OK, so that can cause, perhaps, be an explanation for some of the wild swings we’ve seen this year. We talked about the risks for an individual investor. As you said, we’re not recommending the strategy. We’re just try and unravel it because it is playing a role in the markets. We talk about the risk about this turning against an individual investor. What about longer-term or overall vulnerabilities for the market? I mean, there’s some activity here which is definitely influencing the trade.
Jimmy Xu: I think when you separate the difference between the short-term options activities, is what this strategy is, and longer term– that’s what I’d call it– normal option activities.
Greg Bonnell: Longer term, oh, two days? [LAUGHTER]
Jimmy Xu: For institutional investors. And most investors in the option space. Other than these type of strategies, they typically buy and sell options that are one month or longer maturity. So if you look at what’s happening in the VIX index– that’s the CBOE Volatility Index– and the S&P 500 this year, it’s actually been pretty muted despite the volatility that we have seen. What’s interesting is that these volumes, because they are one day to expire, they actually don’t show up in any of these metrics for the VIX index so that the impact for traditional options investors are actually quite limited. But on the short end, I think what’s interesting is that given all of this open interest, all of these volumes being absorbed by the market really easily, I think the market makers are really happy to take that flow even though there is no commission. We know that bid offers on options are typically wider. So having that two-way volume– selling in the morning, buying in the afternoon– is really profitable for the market makers. So these flows, despite the fact that they’re 40% more– they consist of 40% of the market– they have been absorbed by the market makers actually quite easily. So if you’re not watching, you might just miss out on these type of trading that’s happening.
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