Overnight 0DTE Options Strategy

David

2 years ago

Following up on two posts that discuss the overnight effect for US stocks, I combine my previous analysis with the surging popularity and liquidity of 0DTE options to create a simple overnight trading strategy. The strategy has the potential to create consistent income by risking occasional large losses.

0DTE Options

Ultra-short-term options with imminent expiration are all the rage with a large retail crowd YOLOing directional bets in the hope to profit from strong intraday trends. In practice, however, this often proves difficult, because option buyers need to be right with perfect timing to win against the rapid decay in value as expiration approaches. A study shows that retail traders lose money on average with long 0DTE option strategies even before significant trading costs. Most profitable strategies instead aim to profit from this theta decay during stable markets by selling expensive options. As a significant amount of time value deteriorates overnight for futures options that expire the next day, selling 1DTE put options on the S&P 500 futures (ES) is an excellent, though risky, way to enhance an overnight trading strategy by adding a volatility risk premium to the positive overnight effect.

Time decay accelerates significantly the closer an ATM option
gets to expiration; borntosell

Volatility Risk Premium
The seller of an at-the-money or out-of-the-money option earns the option premium by expiration, if nothing changes. He gets paid to insure other market participants against large movements in the underlying asset. Taking on this risk can be expected to be profitable over time, because insurance has a cost.

A real-life example trade illustrates the point: An at-the-money S&P 500 futures put option expiring the following day currently is worth around $20 at market close (3:50pm; May 2nd, 2024). The index needs to drop 20 points for the option to break even by expiration. Conversely, the seller of the put remains profitable, unless the S&P falls by more than 0,4% the following day.

For the purpose of our strategy the overnight time and volatility decay (Charm and Vanna) generates a built-in advantage by the time the market opens the next morning: Without any change in the index level our ATM put option will be worth around $17 by the time of the EU market open (3am EST), which is my preferred time to close overnight positions. This translates to a 12-15% profit for the seller of the put even before considering the overnight effect, simply by carrying the risk of overnight events on the book and earning parts of the option premium. Including an additional positive overnight drift, the loss in options value can be striking: An 0.2% gap up, which is a common occurrence, will lead to a put option losing nearly half of its value overnight implying a harvest of around 40% of premium received.

An 0,2% slide in the index over night, on the other hand, leads to a comparatively smaller loss around 25-30%, showing a clear advantage for the profit side of the ledger when there is little movement. (These estimates are derived directly from recent real-life trades, but ultra-short-term option premia can vary rather drastically depending on Vix levels or upcoming markt events with a high potential for volatile price moves.)

The basic factors that influence options prices; Squeezemetrics.

The downside for the seller is the convex nature of options, because 0DTE put options can quickly spike by a multiple of their value when bigger overnight moves to the downside occur (ATM put options price roughly doubles overnight with a move of more than -0,5% in current conditions). Maximum profit, on the other hand always remains limited to the option premium received.

In essence, the majority of small overnight moves skews towards the profit side for the seller, while rarer, large gaps favor option buyers. In a live strategy using 0DTE put options the main focus should be on looking for ways to minimize the probabilities of encountering large overnight down gaps while in a trade. I try to accomplish this by using an efficiently short time in each trade, as well as filtering out high probability adverse or low edge time periods.

The Overnight Effect

Essentially all of the historical S&P 500 return occurred during the overnight sessions, which leads to a lot of speculation on how to trade this edge profitably. Alas, simply buying SPY in the evening and selling in the morning will lead to an erosion of all profits due to slippage and transaction costs. Furthermore, a reverse effect with outsized overnight losses often occurs during bear markets leading to deep, painful drawdown periods.

A short recap of my detailed previous analysis on the likely causes of the overnight effect leads to a few common sense filters one can use in the construction of a more profitable strategy by avoiding loss events and likely drawdown periods:

Overnight gains are probably due to two main factors, which should always be in place when opening an overnight trade:

The Overnight Risk Premium: A lot of stock-market risk happens outside market hours, and positive overnight returns in large part are a compensation for taking on that risk. This risk can be mitigated by staying in the trade for as short a time as possible and by closing positions before 8.30am EST when economic data is released leading to unpredictable market jumps. The majority of big overnight losses occurs during bear markets.
Structural Liquidity Flows from options markets: Changes in Vanna and Charm cause adjustments in dealer hedging. With a Vix Futures Term Structure in contango, which is the regular state during bull markets, there is a positive tailwind to the stock market ebbing and flowing with the monthly options expiration cycle. Due to overnight liquidity constraints this is largely realized when the markets open in the EU and later in the US. During bear markets these flows turn negative as hedging requirements increase with rising volatility.

An Overnight 0DTE Strategy

To keep it simple the strategy sells ES put options (ATM; next day expiration; premium received = 1% of trading capital) at every US market close around 3:50pm and closes the position just after the next EU market open at 3:30am EST. My backtests indicate that covering after the EU market open targets the most profitable overnight interval as liquidity comes back into the market.

The following conditions need to be met for the trade to be put on:

There is a cause for positive overnight Vanna flows that push the market up: The Vix Futures Term Structure is in contango and we are not near a monthly options expiration (do not trade on the days around monthly OpEx).
The Meta Strategy indicates a Quiet Bull Market regime. The S&P 500 trading above its 275 dma would be a simplified proxy for this indicator.

That’s basically it, although some bells and whistles are likely to be added to the execution details of a live strategy. For example: Setting a minimum size for the premium, using stop losses or put spreads to control risk, dealing with large versus small opening gaps, and more.

The Risk

Harvesting an overnight risk premium means that the risk is bound to materialize in the form of large losses from time to time. It is an essential quality of all option selling strategies: Frequent, small gains are interspersed by occasional, large losses. Over time even unconditional options selling can be expected to generate positive value, because it harvests a premium akin to an insurance company. However, key to survival is to keep exposure constrained so as not to drown in the interim during the biggest loss events. While the filters above are designed to improve results by screening out the majority of such events, as well as long losing periods, it would be naive to think that all bad events can be avoided.

I found a helpful rule of thumb to gauge the size of such an extreme loss event by looking at how my broker asses that risk: At Interactive Brokers the margin required to short an 1DTE ES put option overnight equals roughly 10x premium, which I approximate as a very rare, worst-case loss for the strategy. My strategy stats show the average loss to come in considerably lower than the option premium received combined with a high win rate well above 70%. I personally feel comfortable with a risk level where the option premium received equals 1% of my trading capital, which accounts for rare extremes – a 10x premium loss would equal a survivable 10% of capital.

Apart from the implied worst-case risk, the high margin requirements for shorting ES options contracts are a major downside to this strategy. A substantial portfolio size is required to cover a margin of approximately $10.000 per options contract at Interactive Brokers. A possibility to mitigate both these disadvantages would be to use put spreads, albeit at a considerable reduction of the potential reward (no pain, no premium) and larger transaction costs. Unfortunately, switching to lower cost SPY options makes a pre-market exit impossible and large jumps following economic data releases are likely to cause a substantial hit to the strategy’s overall profitability.

As part of a multi-strategy portfolio using relatively low exposure (option premium =1% of trading capital), I consider the 1DTE put option overnight strategy a great income-generating addition for my own portfolio that is going through live testing at the moment. Backtests and paper trading are of limited value in option strategies as historical data tends to be incomplete and often inaccurate. Please check back for updates within a couple of months in case any of the above premises fail to hold up in real life!

Please do your own due diligence and tests before jumping into such a strategy! Risks are high and can remain in hiding over long periods of time. This post outlines a simplified trading idea and is not a complete, fine-tuned trading strategy.