Who caused the major drop in the US stock market in August? Goldman Sachs: "Zero-day options", UBS: I agree!

On Tuesday, the three major U.S. stock indexes accelerated their decline in the late trading session, closing near the day's low with a collective drop of at least 1%. The S&P 500 and Dow Jones Industrial Average recorded their largest declines since August 2nd and July 6th, respectively.

Scott Rubner, an expert in researching fund flows for the past twenty years and Managing Director and Senior Derivatives Strategist at Goldman Sachs, believes that the culprit behind the late sell-off is zero-day-to-expiration (0DTE) options linked to the S&P 500 index. These options have exacerbated the downward trend in the U.S. stock market, causing the S&P 500 to drop by about 0.4% in just 20 minutes.

Rubner pointed out that market makers need to maintain a balanced book, so they have to buy and sell stocks in large quantities when a large number of option trading orders come in. On Tuesday, there was a surge in trading of 0DTE put options with a strike price of 4440, with nearly 100,000 contracts changing hands throughout the trading day, with a nominal value of $45 billion. This forced market makers to take action.

As the cost of these options skyrocketed from $0.7 to $9 at the end of Tuesday's trading day, market makers took hedging measures to maintain market neutrality, which in turn meant a massive withdrawal of funds from the stock market. Rubner said, "There was not enough liquidity on the screen to handle market makers' dramatic delta hedging in just 20 minutes."

0DTE Options - "Picking Up Coins in Front of a Steamroller"

Wallstreetcn previously introduced 0DTE options and quoted Wall Street insiders' analogy that selling them is like "picking up coins in front of a steamroller."

Because these options have less than 24 hours until expiration, they can generate huge returns in just a few hours. However, they come with both the possibility of high returns and significant risks, posing major risk management issues for market makers and traders who sell options.

Marko Kolanovic, Chief Market Strategist and Co-Head of Global Research at JPMorgan, warned in February of this year that the explosive growth in 0DTE trading volume could cause a market disaster similar to the one in early 2018. Kolanovic's model shows that the daily nominal trading volume of 0DTE options is currently around $1 trillion. Once the market experiences a sharp decline, market makers may be forced to liquidate positions, triggering a crisis that could result in $30 billion of selling pressure from 0DTE options.

Earlier this week, research reports from Nomura Securities and Citigroup highlighted the selling threat posed by the extremely active trading of 0DTE options this month.

Nomura estimated that on Thursday of last week, there were approximately 1.86 million 0DTE options tied to the S&P 500 that changed hands, accounting for 55% of the total trading volume of the S&P 500, reaching a record high. With less than half of August gone, 0DTE options trading volume on four days this month has already entered the top ten highest trading days. Nurture's strategist, Charlie McElligott, said that the selling pressure during the trading day has led to changes in the behavior of 0DTE options, which are significantly different from the strong rebound we have seen in the past. Whether it is trading volatility, range, or overshoot, the environment for 0DTE as a perfect tool has matured, but it has also fueled such volatility.

"Thanks to 0DTE, a limited decline in the stock market (less than 1%) can quickly bring the mean back to normal... but anything more painful will cause all bets to fail."

Stuart Kaiser, Citigroup's head of US stock trading strategy, noticed that traders' preference for 0DTE options has shifted from bullish to bearish. Their data shows that in the past 20 days, the trading volume of bearish options has been nearly 10% higher than that of bullish options, while in the previous two months, most of the investment funds flowed into bullish options.

UBS: Selling coincides with a wave of buying 0DTE put options

UBS's trading department also agrees with this view. In a report on Tuesday, the team conducted a case study of three particularly busy trading days for 0DTE: July 27, when news of the Bank of Japan's possible hawkish monetary policy came out; August 4, when the latest monthly non-farm data in the United States was released; August 10, when the US CPI inflation index was published.

The UBS team found that the selling on the afternoons of July 27 and August 4 coincided with a wave of buying 0DTE put options. On August 10, the morning's plunge was also driven by put option trading. When investors started to profit from these contracts later in the day, the market sentiment changed, attracting traders to buy call options to chase returns, further boosting the stock market.

Rubner said that the amplification of the impact of 0DTE is because trading stocks without affecting stock prices has become increasingly difficult. He estimates that liquidity conditions have deteriorated by 56% in the past two weeks.

The S&P 500 index closed below the 50-day moving average for the first time since the end of March. Data compiled by Bloomberg shows that the average high-low volatility of the index in the past five trading days is 1%, almost twice the level in July.

Rubner warned that the intensification of volatility and the weakening of the upward trend may turn rule-based investors into sellers. "This is no longer a market to buy on dips." Market sentiment and tone are undergoing new changes.