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By Joseph Adinolfi

There's a reason the index hasn't moved much since June, according to a team at UBS

Options traders at work in a Cboe trading pit.

For decades, the process of price discovery on Wall Street followed a clear pecking order: Trading in cash equities and index futures did most of the heavy lifting, while the options market was more of a sideshow.

But the massive growth in the options market over the past few years has finally caused that dynamic to flip, according to a team of trading-desk analysts at UBS. Since 2022, day traders have increasingly gravitated toward S&P 500 SPX options contracts due to expire at the end of the session. These are widely known as zero-days-until-expiry, or 0DTE, contracts - a label that applies to any option that is due to expire at the end of that trading session.

These contracts are known for being hugely risky, given that small moves at the index level can cause huge swings in the options price if it's close to being "in the money." Some have likened them to lottery tickets.

Since the beginning of June, the S&P 500 basically has gone nowhere. The index finished at 7,599.96 on June 1; on Monday, it closed at 7,676.77 - only about 1% above that June 1 level. On a rolling 50-day basis, the trading range for the index is looking conspicuously narrow.

The fact that the popular equity index has been stuck in such a tight trading range is made all the more remarkable by the nonstop flurry of market-relevant activity that investors have been subjected to over the past few months. The Iran war has dragged on, Treasury yields BX:TMUBMUSD10Y have touched their highest levels in decades and the Federal Reserve has returned to raising interest rates. Meanwhile, worries about the eventual returns on enormous levels artificial-intelligence investment have weighed on shares of semiconductor stocks and other AI-related plays.

But after carefully studying options order-flow data from the Cboe, which has an exclusive license to list S&P 500 index options, the analysts at UBS have hit upon one possible explanation, or at least a contributing factor. The team found that traders of 0DTE options increasingly were trading in the opposite direction of the market.

In other words, when the S&P 500 is higher on the day, these traders pile into 0DTE puts, or sell 0DTE calls. When the index is lower, they do the opposite - buying 0DTE calls, and selling 0DTE puts.

This represents a big change from 2024, when 0DTE options order flow showed little relationship to recent moves in the spot market.

The growing popularity of this countertrend trading strategy has likely helped stifle the index's directional momentum, according to the UBS team. Their analysis also showed that daily trading volume in S&P 500 options now dwarfs the market for E-mini S&P 500 futures (ES00) when adjusted for market exposure - a testament to the options market's growing influence.

When adjusted for an individual option contract's sensitivity to moves in the underlying index, daily gross volume in S&P 500 options has eclipsed the volume in E-mini S&P 500 futures contracts by roughly 1.7 to one, the UBS team found.

Data from OptionMetrics showed that trading in 0DTE options has increasingly come to dominate trading across the S&P 500 options complex. Trading in S&P 500 0DTE options as a percentage of total daily volume in the S&P 500 index complex peaked at a record high of 75% earlier this year. Since the start of the summer, that figure has routinely ranged between 60% and 70%.

"It's totally plausible that the hedging behavior associated with this activity is one of the factors that is suppressing intraday moves," said Garrett DeSimone, head of quantitative research at OptionMetrics, during a conversation with MarketWatch.

An increasingly split stock market, with AI stocks on one side and everything else on the other, could also be helping to dampen daily swings, DeSimone added.

"You almost have this bifurcated market, where you've got AI and then everything else. That lends itself to lower correlation and lower volatility at the index level," he said.

-Joseph Adinolfi

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