Should the New Fear Gauge Impact Your Portfolio?

For the vast majority of investors, it should not matter much at all, but for the day traders, pay some attention. According to data compiled by Goldman Sachs Group Inc., by the third quarter of 2022, 0DTE (zero day to expiry) contracts accounted for more than 40% of the S&P 500’s total options volume, almost doubling the percentage from before they were available every day. This suggests a significant shift towards speculating on extremely short-term market moves. This might be a lingering COVID related meme trader impact or it could be structural.

Here is the math of the expected trading range:
With the S&P 500 at 4133 to start the day and the opening 1-Day VIX at 8.8:
4133 x 8.8 x SQRT(1/365) = $19.03 (1 std. deviation)
95% chance the S&P 500 will close between 4095 and 4171.

Exchanges like the CBOE make their profits primarily from trading fees and listing fees so they have every incentive to get more trading done. Warren Buffett first said in their 2002 investor letter that derivatives are “financial weapons of mass destruction.” And while GEICO and Buffett frequently use derivatives to hedge risks, the short-term nature of daily options has changed the volatility structure of the markets. Here is a good explainer for those that want to understand the impact a bit more. Essentially, options provide for the creation of leverage. It’s the use of leverage that is destructive along with the very short time frame. We use options for hedging and income generation in many of our portfolios and they have significant benefits for investors when used prudently. While I do not have a problem with speculation at all, when combined with leverage, it can be destructive to one’s portfolio.

Enter the newest volatility index. It looks to measure the implied volatility each day. I mean really, NO ONE INVESTING AND I MEAN NO ONE, should care one iota about the day-to-day noise in the markets. And the media should avoid reporting on it. It should have absolutely no bearing at all on your retirement portfolio. But what has become clear over the years is the investment horizon for many has moved from your long-term goal to your annual performance, to your quarterly performance and now, apparently, to expectations for the day. Far too many investors are making decisions in a very short time frame when the use of proceeds are for much longer term needs. While this is good for the brokers and exchanges, it’s not good for the emotional side of investor decision making. This is just my 2 cents worth of advice for the average retirement saver. If you are a day trader, it’s another tool for you to speculate with.

Cboe Global Indices: VIX1D Index Dashboard

For the day traders, understanding that the premium you pay for a 1-day option will tend to expire worthless or for less than you paid for it is extremely high. History is clear that realized volatility (the experience you get) is almost always less than implied volatility (what you pay for the ride). Time decay is most acute the closer you are to expiration. Because of this, the gamma effect is magnified. What this essentially means is that the more leverage that is in play, the more market maker hedging can add volatility to markets during the day.

At this point, this is only available for the S&P 500 index. It has not yet been applied to individual equities, many equities have options that expire weekly on Fridays.

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