What are zero-day options? Here's how they're taking over a key corner of the stock market and why they could pose a big risk

• It's been one year since the CBOE launched zero-day options contracts and they're starting to take over the stock market.
• Zero-day options expire the same day they are issued and they now make up 50% of S&P 500 options activity.
• A new ETF has launched utilizing the options contracts, and with enough scale they could jolt the stock market in a big way.

There's a new options trading product that is taking over Wall Street, and it could ultimately pose a big risk for the stock market as it gains in scale.

Zero-day options have quickly become a major force in the market, even as some observers have dismissed them as "just gambling" or the "fantasy football of option trading."

What are zero-day options?

Zero-days-to-expiration option, or 0DTE, strategies involve buying an option contract on an underlying security the same day it is set to expire. It's a high-risk, high-reward strategy that took off during the meme-stock craze of 2020 and 2021 as more retail investors started to implement Reddit-influenced YOLO trading fads.

Options contracts are already risky. For a typical long-put or long-call option to turn profitable, the investor needs to not only correctly predict the future direction of a stock price via its strike price, but also the timeframe in which the strike price is reached.

Narrowing the expiration to a single day means high-risk options bets play out in a matter of hours, not days, weeks, or months like typical strategies. But that high risk means the options are incredibly cheap, affording investors the ability to add serious leverage and gain a lot of exposure for not a lot of money.

To be clear, every option contract ultimately becomes a zero-day option on the date of its expiration. But CBOE took it one step further in September 2022 by launching one-day options contracts every day of the week for the broad indexes.

Now, they already make up a whopping 50% of total S&P 500 options trading activity, according to JPMorgan.

What's the risk of zero-day options?

Most of these zero-day options are being utilized by institutions to hedge out risks and, in some cases, to collect income by selling them.

"High-frequency traders appear to be the main users of 0DTE and most trades are very short lived (unwound before the end of day)," JPMorgan said in a recent note.

By contrast, about 30% of these options contracts are traded by individual investors, according to the CBOE.

The risk to investors is they could lose all the money they spend on options. But the risk to the overall market is that if these options reach a big enough scale, they could exacerbate volatility and lead to wild swings, JPMorgan warned.

"If there is a big move when these options get in the money, and sellers cannot support these positions, forced covering would result in very large directional flows. These flows could particularly impact markets given the current low liquidity environment," JPMorgan's Marko Kolanovic said earlier this year.

He estimated that a large daily stock market move, either up or down, could spark cascading trades that result in intraday buying or selling on the order of roughly $30 billion.

Zero-day options ETFs

Meanwhile, Wall Street keeps piling into the 0DTE trend. Defiance recently launched two ETFs that write puts via zero-day options on the S&P 500 and Nasdaq 100. The strategies, which trade under the tickers JEPY and QQQY, aim to offer "consistent and outsized monthly yield distributions coupled with equity market exposure," according to the company's website.

While the combined assets in the two ETFs are only $20 million, JPMorgan said if they grow big enough, they could have a sizable impact on the stock market similar to the short volatility ETFs that imploded and exacerbated a sell-off in February 2018.

"If these funds (and others like them to-come) collect material AUM, it could exacerbate the tail risks 0DTE options pose," JPMorgan said.