Morgan Stanley’s Hot New Tool Makes It a ‘Buy’

By Jon Markman

Volatility is increasing for systemic reasons, and that is a big opportunity for long-term investors.

The S&P 500 closed unchanged on Tuesday, yet traders were frantically buying and selling behind the scenes. It's a new reality driven by zero days to expiration options, a relatively new investment tool.

The mechanics of 0DTE options are a big win for Morgan Stanley (MS).

The defining feature of 0DTE options is that they expire on the same day they are issued. This extreme, short-term structure offers a big advantage for speculators.

Options give the holder the right to buy or sell an asset at a fixed price, by a given date. But a large portion of the cost is based on the life of the contract, or time value. 0DTE options largely eliminate time value, thereby creating greater leverage.

A well-timed 0DTE option can produce 1x, 2x or even 3x daily returns. The prospect of huge profits has lured legions of small speculators.

Analysts at Goldman Sachs (GS) note that almost half of all of the options traded daily on the S&P 500 index are now small-lot, 0DTE contracts, according to a note in the Financial Times. These small investors have been seduced into the premise that they can collectively force losses upon sophisticated institutional investors.

This David vs. Goliath theme played out in 2021 as so-called meme stock investors pushed shares of GameStop (GME) to triple-digit gains. During the process, Melvin Capital, a noted short seller, lost $6 billion and was forced to shutter.

Small investors clamoring after 0DTE index options are betting on a repeat. That is doubtful, and I will explain why.

You see, every option trade involves an actual contract. For every contract holder or buyer, there is a corresponding seller or writer. Wall Street's largest investment banks are on the other side of the 0DTE option frenzy, often as sellers.

To offset risk, the bankers buy or short the S&P 500 index in the opposite direction of the corresponding 0DTE bet. In theory, this is a riskless trade for the bankers. But the growing concern is these trades are becoming extremely large as 0DTE interest grows, exaggerating volatility. In some extreme cases, simple hedging may lead to market moves exceeding 5%.

Reuters reported on October 13, 2022, that the bulk of a 5.4% swing in the S&P 500 was the result of this short-term hedging phenomena. That session, like this past Tuesday, featured a Consumer Price Index report.

Shares opened sharply lower on the stronger-than-expected CPI data only to reverse all the early losses and close higher by 2.6%.

The extreme volatility might seem like a big red flag for bankers. It is not.

Unlike the meme stock rally in 2021 that caused so much pain for professional short sellers, hedging S&P 500 contracts is riskless to bankers. The S&P 500 is an index of 500 of the largest companies in the world. Liquidity is extreme, buffered by other financial instruments and tools.

Moreover, option contract trading is a zero-sum game. For every winner, there is a loser; 0DTE option trades stack the odds heavily in favor of bankers.

Morgan Stanley is the leading market maker at the Chicago Board Options Exchange, according to a note in 2022.

Executives at the New York-based firm reported in January that Q4 trading profits soared 26% to $3 billion. Chief Financial Officer Sharon Yeshaya said that trading was a bright spot in a tough macroeconomic environment. She noted that volumes continue to surge.

The rise in popularity of 0DTE options makes sense. For a large portion of smaller, neophyte traders, buying and selling index options that expire that day must feel like the meme stock era revived. This is a fool's errand, according to findings in an MIT Sloan report.

Small investors hold no advantage over larger investors, especially market makers.

Long-term investors should take the other side of this trade. Pocket the winnings by buying Morgan Stanley. As always, conduct your own due diligence beforehand.

That's it for today. I will be back with more for you real soon.

Best wishes,

Jon D. Markman

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