June 8, 2023 · Blog Posts
Three Key Features to Manage 0DTE Options Risk
When I first started working at a proprietary trading firm in 2003, option expiration was a special day. Traders cultivated and nurtured their option positions for months. Painstakingly setting volatility levels, buying and selling options, and constantly hedging, all to maintain their desired risk ratios and accumulate edge. The night before expiration, a firm-wide change freeze went into effect. You couldn’t even restart a printer let alone release a new version of software. If it happened to be triple witching day, where the futures, index, and equity options all expired on the same day, the change freeze went into effect the week before. For one day of the month, everyone at the firm was on pins and needles waiting to see how things would shake out at the end of the day. When it was all over, everyone took a deep sigh of relief and enjoyed the expiration pizza and drinks.
Fast forward to today and the excitement and mystique of expiration is gone because expiration day is every day. The rise in demand for shorter-term option expirations by retail and institutional investors drove the CBOE to list options that expire every Wednesday and Friday in 2005 and then in 2022 the CBOE added options that expire every Tuesday and Thursday. While the excitement and mystique of expiration is gone, the risk has increased. With the surge in volume in Zero Days to Expiration (ODTE) options, where investors buy or sell options only on the day of expiration, Risk Managers need the right tools to effectively manage expiration risk.
Rival Risk provides three key features Risk Managers need to manage expiration risk.
- Real-time Pin Risk
- Real-time Position Alerts
- User Defined Scenarios
On the day an option expires the key factor driving P&L is where the underlying price settles. If you hold options to expiration and have a position in a strike on either side of the current underlying price, a small move in the underlying will have a significant impact on your P&L. If the underlying price settles right on the strike price, you could have significant pin risk, where you’re not sure if the option will be assigned. The real-time Pin Risk feature allows Risk Managers to scan option positions across all accounts and identify each position where the strike is within a user defined width from the current underlying price. Risk Managers can easily see which account has the position, as well as the call, put and net position on each strike. The Risk Manager knows which positions are in jeopardy of being pinned and can proactively work with the Trader to close out a position before expiration if needed.
Some Risk Managers don’t want certain accounts to hold or initiate a new position on the day an option expires. One significant risk with 0DTE trading is firms with antiquated risk systems won’t even know the 0DTE position was put on until the next day. Rival Risk allows Risk Managers to set up real-time alerts to notify everyone in the Risk group if an account has a position within a certain number of days to expiration. Risk Managers can set up the alert for a specific set of accounts or all accounts, define which product category the alert applies to, the start and stop time for the alert, and who should be notified when the alert triggers. The system also allows Risk Managers to set a reset condition to send a notification when the position in the account is closed out. The real-time alerting feature provides Risk Managers peace of mind, knowing they don’t need to worry about certain accounts the day of expiration.
User Defined Scenarios
The scenario analysis feature in Rival Risk allows Risk Managers to model changes in the underlying price and volatility to see the resulting P&L and risk metrics across accounts. Running scenarios such as the underlying price going up or down 25%, 50% or 75% helps Risk Managers identify the impact to profitability if the market changes significantly on the day of expiration. For example, if an account has out of the money puts, the worthless put position might fall under the radar. If the market drops significantly on the day of expiration, the puts that were once worthless could now be in the money, resulting in a significant loss for the short put position. The scenario analysis feature brings the short put position to light and allows the risk manager to proactively manage the potential risk.
The rise in popularity of trading 0DTE options brings significant opportunity to trading firms but Risk Managers need the features offered in Rival Risk to effectively monitor daily expirations across many accounts and products. While Rival Risk can’t bring the excitement and mystique of expiration day back, it can help firms ensure the next expiration day isn’t their last.