Analysts at JPMorgan have just flagged a potential huge new risk in markets – and it’s one you’re going to want to pay attention to. It has to do with the record rise in 0DTE, or “zero days to expiry”, options trading – and if these analysts are right, it could turn a 5% intraday stocks drop into a 25% catastrophic plunge. Here’s what you need to know now…

What are 0DTEs?

Simply put, these “zero days to expiry” options are contracts that time out on the same day and that can be tied to the price of an index, ETF, or single stock.

Like all options, these contracts allow you to buy or sell an asset at a specified price on or before the expiration date. “Call” options give you the right to buy the asset while “put” options give you the right to sell the asset, regardless of whether you own the underlying asset.

0DTEs work like lottery tickets, allowing you to bet on the closing price of an underlying asset, without much upfront capital, and with massive leverage. So, a lot of people have been using them as a quick way to profit from sharp one-day moves.

Here’s an example of how it works:

You buy an 0DTE call option on the S&P 500 index with a strike price of 4,020, 0.5% above where it is currently trading at 4,000.

The contract has a multiplier of 100, so if this call option is priced at $10, you’ll need to pay

$10 x 100 = $1,000

and your total exposure to the index is

4,000 x 100 = $400,000.

If, at the end of the day, the price of the S&P 500 is lower than the strike price of 4,020, your option is “out of the money” and all you’ll lose is $1,000, the price you paid for the option (also known as the option premium).

If however, the S&P 500 closes 1.5% higher on the day, at 4,060, you’ll have

(4,060 - 4,020) x 100 = $4,000.

After subtracting the option premium of $1,000 you paid, you’ll have made net profits of $3,000 in a single day, a 300% return.

You can understand why these options are particularly popular with day traders and algo players. According to Goldman Sachs, over 40% of all S&P-related options now expire on the same day, more than double the volume from a year ago.

The shorter-term S&P 500-related options have become the market’s most preferred. It wasn’t always that way. Source: Goldman Sachs.

So what’s the problem?

There are always two parties to a trade. In the example above, the dealer who sells you the call option gets to pocket your option premium of $1,000 if your option is out of the money at the close of trading. On the other hand, the dealer stands to lose $3,000 if your option ends up “in the money”. To hedge the position and potential loss, your dealer will need to buy a proportion of the index.

Now imagine that tons of people pile into 0DTE call options in a single day (think: r/WallStreetBets). Now those dealers’ hedging needs will increase, and as they buy more of the S&P 500 index to hedge, they’ll also drive the price of the index higher. The need to hedge could very easily overwhelm the liquidity of the market and drive sudden, huge price swings. And the same is also true for speculation on put options – market prices could be driven significantly lower, increasing volatility and exacerbating swings.

And that’s why JPMorgan recently sounded the alarm about these options. Its research shows that the sheer volume of 0DTE trades could magnify any moves in the S&P 500 by up to four times. In the worst-case scenario of thin trading, and in the extreme event that all traders sell their S&P 500 0TDE option positions, a drop of 5% in the index could snowball into an additional 20% drop – all in a single day.

Analysts at JPMorgan fear that trading in the popular options, which are now hitting daily volumes in the neighborhood of $1 trillion, could deliver a volatility shock similar to the 2018 “Volmageddon” crash, where two popular exchange-traded products saw 80% of their value wiped out in a single day. That event touched off a chain of events that impacted other volatility-related products, resulting in billions in losses.

The additional market impact (y-axis) from all 0DTE options unwinding at various levels of initial market shock (x-axis). Source: JPMorgan.

Should you be worried?

As we know, in markets, nothing is isolated and there’s always the risk of a “butterfly effect”, where small changes in one corner can cause big changes in another. Since many of the 0DTE options are based on the S&P 500 and related ETFs, the risk of a massive drawdown in a single day can’t be easily dismissed.

If you’re like most investors, you’ve got exposure to the S&P 500 in one form or another, and the risk of your holdings falling more than 20% in a short span of time is probably of genuine concern.

What makes this situation particularly tricky is that we’re unlikely to be able to predict what will happen, when it will happen, and how bad it’ll be. In times like these, it’s especially important to pay attention to diversification.

So, if the stocks in your portfolio are mostly from US companies, it’s high time you think about investing in shares from other places. (For example, Europe.)

And if your portfolio is devoted entirely (or mostly) to stocks, it’s time to think about some of the other asset classes out there. Investment-grade credit, the US six-month Treasury bill, and the three-month cash deposit all offer competitive yields to the S&P 500, and with less risk. That makes this an excellent time to cast your net a little wider and seek out assets with better risk-adjusted returns.