Unexpected Drop in Stocks Linked to Zero-Day Expiry Options

Wall Street experienced a typical trading scenario for most of Wednesday, with U.S. stocks on track for exceptional performances. However, the upbeat trading session took an unexpected turn with a sharp decline occurring within the final two hours.

Market analysts attribute the sudden drop in the S&P 500 index, post 2 p.m. Eastern time, partially to the surge in zero-day to expiry options (0DTEs). These options have seen a significant increase in activity starting 2023, attracting both individual investors as 'lottery tickets' and large funds for tactical protection.

Zero-day options are budget-friendly for buyers and permit the holder to trade a stock or other asset at a set price prior to expiration. In the context of the S&P 500, they are generally cash-settled, which means that 'in the money' positions can lead to cash distributions or profit on sales.

Before the afternoon's volatility, the S&P 500 was on the verge of surpassing its historical closing peak of 4,796.56 set on January 3, 2022. The Dow Jones Industrial Average and Nasdaq Composite were also seemingly en route to their 10th consecutive day of advancements.

However, the S&P 500 and Nasdaq concluded the day with a decline of 1.5%, and the Dow Jones settled 1.3% lower, interrupting their nine-day streak of gains. Analysts have suggested that the overbought market and lighter trading volumes typical ahead of the end-of-year holidays likely intensified the drop.

In tandem with the market downturn, the launch of a new ETF by ProShares that exploits short-dated 'zero days to expiry' options on the S&P 500 may have had an impact. Such market events can provoke reactions similar to those preceding a government bond auction, wherein participants may sell off in anticipation of the new supply.

The effects of Wednesday's sell-off may have been amplified by the pre-holiday trading atmosphere, but as of the following Thursday morning, stocks appeared to rally once more with all major indexes showing recovery.

stocks, options, trading