ETF Edge - Options Action Exploding: Zero-Day Expiry Trades Take Off 7/17/23

Episode Date: July 17, 2023

CNBC’s Bob Pisani spoke with Ed Tilly, Chairman and CEO of Cboe Global Markets, and Mike Green, Chief Strategist at Simplify. Options activity has exploded and a new trend called zero-day-to-expiry options has taken off this year. Our panel did a deep dive on what’s fueling the rise in activity – and also weighed in on crypto ETF filings, as more applications fall into the SEC’s lap. In the “Markets 102” portion, Bob continued the conversation with Mike Green from Simplify. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange traded funds, you're in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani. Today on the show, we'll do a deep dive on options trading with the man in charge of the largest options exchange in the United States. Options activity has exploded and a new trend called Zero Data Expiration Options has taken off this year.

We'll also get an update on crypto EAPF filings as more applications fall into the SEC's lap. Here's my conversation with Ed Tilly, Chairman and CEO of Cebo Global Markets along with Mike Green, chief strategist at Simplify. These zero days to expiration options, they're typically S&P 500 options. They have monthly or weekly options that are principally traded on the final day of the contract. Those of you don't know that. So explain to us what's going on here. Why have they suddenly caught on with the investing community?

Thanks, Bob. Really what's caught on is the ability for investors where they're most certain, and that is the shortest duration of time left in a contract, much more comfortable predicting and having an opinion on the market in the short term, then let's say one week, three weeks, or even a year. So it's really become attractive and garnered a lot of interest in being able to express that opinion in the short term. And then the other characteristic primarily when we're trading SPX options is their cash settled. That means at the end of the trading day, the net results of that trade is settled in cash,

not physically delivered like a stock or an ETF. You know, Michael, let me bring you in. I'm an amateur behavioral economist, and there's a number of things here that are obviously very easy to explain in terms of why this kind of trading is popular with retail traders. So I want to use an example of how a retail trader might use these and get your comment on them. And for those of you don't know, this is an example. Suppose you think the S&P is going to go up on that day. So you could open a position and sell an S&P 500 foot, which would be a bullish call. You'd collect a premium, say a dollar.

So if you're right, the SP closes up, the put expires worthless, and because, as Ed said, it's a cash settlement, you get a dollar. As a retail trader, I can easily make, Mike, a one-day bet on whether I think the SPP is going to go up on that day. I can sell a put, pie, call, whatever. And what happens is it's a cash settlement, and I can do it all over again tomorrow. So essentially, you get that shot of dopamine every single day. It's a fantastic shout of dopamine. And as Ed mentioned, these are cash-settled instruments, and so you end up with a situation. in which it almost never existed.

It just seems like either cash in your pocket or a bet, and that would actually take issue with Ed's expression of the use of the word opinion. These are actually bets that are being placed in the market with cash for a relatively random event. Does the market go up or down on any given day? Yeah, so does anything concern you about this? I mean, you and I have talked about this before. Options trading is growing, partly because there are more options trades that are available.

Ed's done a brilliant job of expanding the business of options trading over for the many, many years to his credit, but is there any worries about this? Well, there have to be worries about anything new that you introduced to the market. So when you create a new product like a zero data expiry option, we have to be thoughtful about how that's going to impact market trading behavior, market structure, et cetera. That type of dynamic, where we're actually looking at the S&P 500 single-day options, we're actually seeing an extraordinary amount of trading volume in the underlying instruments

that is driven by these options at this point. That's my source of concern, that we've created conditions under which we could overwhelm the system under certain conditions. Yeah, Ed, how do you respond to that? I mean, you understand some of these concerns about long-term the option tail-wagging the dog at this point. How do you respond to these concerns?

Yeah, I would say I would look, actually, take another level deeper in the statistics of what's trading, and we see open and close all day long. So this is not open necessarily at the be opening bell and waiting until the end of the day to see whether or not the position that you've taken is paid off or not. This is interday trade, buying and selling all day long,

to be clear. So this is not amassing a great amount of open interest and seeing what happens at the end of the day. That is not what we're seeing here. And then further, if we look at the statistics, this is not one single strategy. This is not strike specific. What I mean by that is not everyone is piling into the same strategy.

Quite the opposite. We see a great distribution among strikes in any given day. So there's not a concentration of opinion. And then the nature of the trade, the majority of them are risk limited, meaning it's open long, open long call, open long put, or a credit spread that is buying one option and selling another. So we see really limited risk at the end of the day on how these trades are being. answered. Michael, I would imagine, and I want to go back to this, but I imagine all of this trading activity is striking, is taking notice, being taken notice by the ETF community, right? That, I mean, they must be salivating around it. You run an ETF that uses options.

Tell us what the ETF community is considering around. So what I tell you about the UTF community is we're primarily interested in selling these options because they are so profitable to sell. And so the strategies around buying the options, and so the strategies around buying the options, which are primarily those that are pursued by retail. So Ed correctly pointed out that a lot of these are buy to open coming from retail accounts. On the institutional side, we know that 85% of options are going to expire worthless on any given day. That creates conditions under which we want to sell them.

We want to actually create a very high return and very consistent payoff associated with it. Traditionally, we've been focused on one-month options or quarterly options. We've moved into the weekly options. Now people are beginning to explore the idea of selling daily because if you have something that has a high probability of success, you want to do it as frequently as possible. So there's going to a daily option increased, does going to a daily option pose any risk to the stability of the underlying stocks or the markets in general? Is there any risk that, sorry, use this again, but the option tail could wag the equities dog

here? Well, so as Ed pointed out, these are tightly, you know, there's a lot of different strikes, but those strikes are very tightly distributed. Very few people are entering into a one-day or a zero-data expiry option that's 5% or 10% out of the money. Almost all of these are happening within 1% to 2% of what we call at the money strike, the spot strike. When that occurs, the actual process of making a market in these options leads the market makers to suppress volatility. So they're constantly trying to make as many of them expire worthless as they possibly can, managing their exposures. The problem is if something happens that drives us out of the way.

of that range in a one-day basis. We saw this in November of 2022 when there was a CPI surprise and the market rallied 5% almost instantaneously. That was actually people chasing what's called the gamma, a phrase people have probably heard associated with meme stocks. Now that's happening with the S&P. How about that, Ed? I just want to go back to Michael's point here. Michael has said that while it's not clear what the impact of higher levels of options trading could be, I think it makes a valid point. Years ago, there were only quarterly options, and we had one month option, now we have one week options, now one day, essentially. And his point, I think, that this increases the impact of the options on the underlying securities. Is there a point to this?

Do you think? There would be, and I think the other comment I think is a little bit off, is marketmakers can't make an option trade out of the money or expire worthless. That's impossible. We're talking about the U.S. benchmark here. This is not a simple, a low market cap meme stock, for example, this is the U.S. market. So a market maker having the ability to make something expire worthless doesn't make a whole lot of statistical sense to me. And then I'd also say I'd look at the open and close and the nature in which market makers, professionals, like the group standing behind me, are hedging. They are not necessarily running over to the futures market and trading underlying futures. They're trading option to option

in favor of those options that expire similar time frame as the opening transaction. So, for example, if a sophisticated retail customer is buying an option, a marketmaker would look to another option as their hedge and not necessarily run to the futures market. So a little bit different when we're talking about the nature of the cash settlement here and then the exposure and then the overall breadth of the market. You don't have a problem with sophisticated hedge fund people or market. makers hedging their bets on the say, let's just take Apple. Let's use a real example. It's

Apple's, you know, they're going to be reporting earnings. And that day, market makers want to hedge their bets. And you can use this to hedge your bets. Absolutely. You, you, but you have a different concern about, you know, retail people just getting in thinking they're going to make one way best. So I think there's two separate components. One is we use the phrase sophisticated retail investors. And I think there's actually a really important distinction there. because in general, those who are buying options on a consistent basis are doing more speculation than they actually are being sophisticated in terms of a return profile. It tends to be a losing bet.

The second component is what Ed was referring to in terms of the market makers themselves trading the options. We absolutely see that. Actually, there's a suspiciously high number of these options that are settled at what's called the mid, the difference between the bid and the ask, suggesting that the dealers are trading them amongst themselves, hedging exactly as Ed is highlighting. The challenge that emerges is when things don't function normally. Because if you move outside of that range, the options no longer exist. And then they need to hit the futures market.

Well, let's try a real world example. Let's pick Apple instead of the S&P 500. Sure. You could trade Apple, zero date expiration. Suppose you have a big move in Apple, pick a number, 2%, something a little outside normal, and there's significant trading in the, significant positions in that zero-day options. How could that affect the underlying stock or the volume that's traded? So on individual stocks, we're still at the point where the single-day expiry is only available in certain situations.

They're not available every single day, although that is an area that is being moved to introduce. But to answer your question very specifically, if we're approaching an option expiry, so we're at zero-day-expery, and Apple were to move 2%, the quantity of shares that need to be traded because of what's called the gamma, the change in the hedge ratio that the option maker would use, would use is explosive. So on a 2% move in Apple, you'd see something like 23 shares traded on a zero-day option. On a 2% move, if I were in a three-month option, we'd be talking a single share. So the potential for these types of options to magnify the impact of moves is becoming larger and larger. We're just on volume. If you have a 2%, I get, I'm just picking this 2% number.

A 2% Apple moves 2%. Would it would just the trading? around those zero date expiration options have a significant effect on the volume in general. I'm not even asking about the price. Absolutely. So this is part of what we see when we see option expiry days, as we see an explosion in volume in the underlying securities themselves. Our estimates suggest that you can see up to 20% of the volume in Apple itself being driven by that type of 2% move causing option hedging activity.

You know, I think you're getting my point here. It's perfectly legitimate to have professional market makers seek ways to hedge their exposure. I don't think that's an issue at all. I think what people are looking at is what happened, for example, when the volatility explode, when Falmageddon, remember that a few years ago, and all of a sudden, the unforeseen circumstances happened here. This is just getting bigger and bigger all of the time, and that I think is the issue that we're dealing.

The great irony to you introducing Valmageddon was actually, I was involved with that trade on that day, and it predicted in advance that that product would go to zero on a 4% decline in the S&P, which seemed crazy when it was made. a year before that, but the reason why it's precisely what you're highlighting, Bob. It's when things happen that aren't expected. And when we create products like this, things that have happened in the past have a different impact.

Again, this question is who's doing the trading here? Retail traders are obviously very significant, and market makers are involved making a market on the other cycle. Retail traders are involved. So it's hard to sort the threads out on this. Is it your impression that most of this trading still is done on a retail level? Who's initiating these trades on the last day of trading? So on the initiation, we would suggest on the actual initiation process, we'd suggest about

a third of the trades are coming from retail and about two thirds are coming from institutional. Retail is biased to buy, the institutional is biased to sell. In between those two, as Ed was pointing out, there's all sorts of market maker activity. And they actually represent the vast majority of it because, exactly as he's saying, they're trying to open and close their positions by canceling them out with equivalent options. Ed, how significant, I don't think we put up any much data, but I want to and let people know how significant this has become. What portion of, say, trading activity in S&P options is zero days to expiration? How big is it now? Can you give us a number?

About 40%, about 1.2, 1.25 million contracts a day. But as I point out earlier, this is not just opening a position at the beginning of the day. This is trading in and out all day long. And so we don't have this monster amassed open interest at the end of the day. This is really a lot of two-way flow. But retail numbers are slightly lower than Michael. It's probably closer to 25 that we see. But nonetheless, it is a growing retail interest. But 40% is pretty, that's an astonishingly successful products for one that essentially,

even though obviously options expired on the day for, you know, since they started in the 70s. But this is an explosively successful product. It's amazing. Yeah, particularly when you consider in that denominator, is actually the option volume of these themselves, right? So they have driven the option market. We're actually seeing volume at the traditional reference points, things like the VIX, the 30 day.

We're seeing that fall. So it's not the option activity overall is growing, it's these options. Yeah. Ed, I want to just bring you- We've actually had growth in third Friday as well. Yeah. You can say that again, I'm sorry.

He's disagreeing in my analysis. Yes, we've seen here over year growth in third Friday as well. This has just been so incredible. fast-growing that this is gaining all the interest. But I want to point out to the viewers that this is not happening organically. It's happening largely because CBO has successfully introduced new products. You had five-day contracts on three days of the week, and now you have them on five. And is that not, that didn't happen a couple of years ago.

Your new products is a major reason we're getting this successfully. So, we do agree? I totally agree with that. Go ahead, Ed. I was a year ago in May. You're exactly right. Okay. So in that time period, I mean, one of the things that we've seen,

you talked about the idea of institutional investors using it to hedge. Let's say I'm worried about a Federal Reserve meeting. A single-day option gives me the opportunity to protect my portfolio against equity exposure on that day. Yeah. And again, the beauty of it, that dopamine shot, it's one day. You're making a bet on one day and you're closing out. You're not worried about what's going to happen a week, two weeks, a month.

Or it's removing the dopamine. by allowing me to sleep at night with my investors' money, right? So that's actually a very interesting component. The thing that's so interesting, Bob, is if we go back to last November or we go back to last September when these products began to be introduced, we would see levels of implied volatility around things like Fed days explode. But what's actually happened is the institutional industry, the institutional investors have figured out the joke on these, and they sell them relentlessly.

So now we're seeing Fed days emerge with no noticeable increase in what's called the implied volatility or the price that's priced into that move. Yeah. Ed, I want to just hit you on another subject while I've got you here. CBO has several applications for Bitcoin ETFs to list on CBO. I know you're handling Wisdom Tree, Van Eck, ARC as well as. Could you handicap for us the chances the SEC will approve these applications this time? A lot of people seem to think this surveillance sharing agreement with the exchanges that you've announced. I think NASDAQ has announced it as well.

with BlackRock, is certainly going to make a big difference. Will it make a difference and what are the chances? Everybody's been waiting for years and years for this one. I've been wrong for years and years, but what we are committed to, and not surprising, like Michael's business, the more transparency we can give our regulators. Their main concern is the average investor and their safety and security. And running these transparent and open at markets where that is key to success. We'll keep giving more information to our regulators.

We want them to have every bit of information that we have at our fingertips so that the surveillance and the confidence for all investors is top-notch. So we'll keep providing more information. This is maybe a step closer, but very, very difficult to handicap what's going to come out of a regulator. Well, the community seems very excited. The community has been wrongly excited in the past. but it does seem to address a portion of their concerns. What I'm not sure is whether it addresses all of their concerns.

I think they're going to go fighting, you know, rather significantly. Did you follow this ripple ruling last week where a court essentially gave partial clearance to the idea or partial OK to the idea that a Bitcoin ETF might be approved this time? I mean, you have to read between the lines. It wasn't a clear victory for the crypto community, but it was a partial victory. Does that matter at all in their thinking? Do you think?

I'd be interested in here, Michael's view. For us, it's just more clarity on distinction and what it is actually that we're trading, what the underlying that we may be trading, what the exposure is, but doesn't give me a whole lot more confidence in an approval that would be imminent. As I say, more and more information

more and more clarity from the SEC. We'll continue to provide that information, but I don't know that I would change my handicap a whole lot. You have any thoughts on this? Yeah, I mean, this is an interesting situation in which the SEC has effectively ruled that the institutional investors who had full disclosure and awareness

were offered an investment contract. And that's a security. That's a security. Okay, but... But the exact same thing sold in the secondary market to retail investors has been deemed not a security. Does that make sense to you? It makes no sense.

Yeah, under the ground. that what, well, they're buying it on a exchange and therefore they don't know they're supporting Ripple? They do not understand that. That's absurd. Was that? No, I just think it's a bad ruling, but we'll ultimately see how that plays out. I agree with Ed that the entire space is struggling for clarity.

Now it's time to round out the conversation with some analysis and perspective to help you better understand ETS. This is the Markets 102 portion of the podcast. We'll be continuing the conversation with Mike Green from Simplify. And Mike, we had a fascinating discussion with Ed Tilly from CBO about zero days to expiration options and how they're growing. The ETF community is really looking at these carefully, and I know you at Simplify, you run ETFs that have options and use options in them. Handicap this for us. How long before you think the ETF community is going to capitalize on this?

And I know it's tough for you to talk about it, but are you looking at this yourself? So we are actively exploring products that involve zero. with data expert options. We have multiple products that are designed to take advantage of what's called the volatility risk premium, the ability to sell options and have them expire worthless basically 85% of the time, right? So when you have that type of high probability trade, it naturally lends itself to income replacement strategies. We have products that are targeted at that. And if you think about that probability and the ability to do it over and over and over again, you're going to get a better statistical payout structure, the more frequently you can do that.

And so we've seen people move from selling quarterly options to selling monthly options to selling weekly options. And now we are actively exploring, others are also actively exploring the ability to monetize daily options on this front. It's a fascinating business. And what's interesting to me is I've been covering the ETF business for 20 years, and it's sort of cornered the market in just about everything that's a typical product, index products, large indexes, individual stocks with slice and dice, you know, current hot trends,

like, for example, cybersecurity or pot stocks or anything else. So new products, new trends in products are tough to come by these days that are successful. Options business has been exploding, and it's really remarkable to me to watch, largely because the industry has successfully introduced new options products. So, you know, 20 years ago, the quarterly options expiration was a big deal, the triple witch. It was huge. And now it's like a non-event, even down here, I have trouble getting the producers interested because nothing happens. There's no price displacement. And partly this is because, partly electronic trading has made it more efficient, but also because it's been replaced by options that are monthly and even weekly. So it's much more

spread out. So the industry is suffering from its own success, I guess. Yeah, no, there definitely has been some component of a dearth of volatility. At the same time, though, those market makers have never been more profitable. So the frequency with which they're able to execute, the sophistication of their trading strategies, the sophistication of their replication is off the charts compared to where it was. I was a, you know, a clerk on the New York Stock Exchange and the New York Mercantile Exchange way back in the day. And you're 100% right. You had very talented individuals who were sitting there with individual books trying to balance. these things, today it's all automated.

Yeah, it's amazing. As mentioned, new products are rare, but we were talking earlier and you were saying that you're expecting alternative products to become very popular. Alternative products to me are things like managed futures or exotic products. There's a little bit out of the mainstream. Why do you think they're coming? Is it easier to get in an ETF wrapper? Is the obvious old ETF wrapper advantageous?

So like many things that happens on Wall Street, there's a lot. actually a regulatory flavor behind it. So in 2019, they introduced this called the ETF rule that made it easier to file for ETFs. This is part of what gave rise. Many of the thematic ETFs that we've seen over the past several years. And then in 2020, there was a rule passed

called the derivative rule that actually provided guidance around how to include derivatives within ETFs. That actually is what created the opportunity that gave rise to simplify. We offer ETS that have wrinkles around traditional exposures, including derivative, strategies either to enhance income, offer increased protection, or in the case of alternatives, you mentioned managed futures.

We have CTA, which is a managed futures, ETF. That actually is directly targeting those hedge fund-like strategies or CTA strategies, commodity trading advisor strategies, that are typically reserved for hedge funds and are really only now becoming viable within the ETF space because of the unique challenges of liquidity. So we've had to design products like CTA to take advantage. advantage of that. And obviously this has the advantages of an ETF, the tax advantages. What about it's always bugged me why people pay zero and 20,

I'm sorry, two and 20, 2% of their of the business and of their assets and amount of and 20% of the profits to hedge funds every year. And is the ETF wrapper a challenge to that? I think it is, and that's part of the reason why actually switched over from the hedge fund space to ETFs, was I saw the opportunity emerging that we were ultimately going to move every type of hedge fund strategy into ETFs. And in the last two years, we've largely done that. We have volatility, premium harvesting strategies like

asphalt, managed futures like CTA. We have... And this managed futures. I mean, they might, I mean, a commodity trading advisor might could charge 2% in 20. Most of them do, actually. So you're actually And what are you charging? 75 basis points. Well, that's a huge difference, right? It's a huge difference. I mean, is there something hidden here? I'm not understanding.

Is that the true cost? Well, one, you could argue that there's the perception of quality associated with paying more, right? And so that certainly can be attractive to some individuals, although the performance of many of the ETFs have outperformed the indices overall. The second component is running on the same rules that you've always heard. The second dynamic, though, is that for many individual investors, it's actually dramatically more tax-efficient to go through the ETFs, than it is to go through the hedge fund structure.

And that's part of the reason why we're seeing high net worth individuals or RAAs, registered investment advisors who are guiding their clients into more diversified portfolios, start to use these ETFs, whereas the hedge fund space is mostly about tax-free institutions. Yeah, and hedge funds obviously don't want to move to an ETF structure because it doesn't make sense for them, right? The economics are much worse for them. Yeah, yeah, it doesn't make a lot of sense. So why isn't this happening more? I mean, why aren't, I mean, it's a $3 trillion hedge fund industry that's out there,

and yet they seem to have captured a certain amount of the market charging, you know, two and 20. Well, while we're nowhere near as successful as the CBOOE with their introduction of zero data entry options growing to 40 percent, as we talked about earlier, we actually are starting to see that momentum shift. And so we are seeing very rapid growth of the alternative space within the ETFs. It's one of the areas we're most excited about. We're also seeing it in fixed income products, et cetera.

So this is going to be an exciting piece. We hope to be one of those who's in the position to help investors. Do us a favor. Let us know what you're doing and let us know if you see some changes and tell us about when we get more on these zero days to expiration option products and any new alternative ETFs that you see coming out there. Michael, thank you very much for joining us. Michael Green is, of course, the chief strategist would simplify and thank you, everyone, for listening to the ETF Edge podcast.

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