The Fine Print of Zero DTE Trading

As zero DTE options expand from indices to individual equities, understanding the mechanics behind expiration becomes crucial for traders. Options expert Mat Cashman breaks down the key structural differences between American and European style options and why the contra exercise window can make or break your zero DTE strategy.

Summary – IBKR Podcasts Ep. 354

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman  

Hi everyone. This is Jeff Praissman with Interactive Brokers’ Podcast. It’s my pleasure to welcome back to the IBKR Podcast Studio, Mat Cashman principal and instructor of the Option Industry Council and OCC. Hey Mat, how are you? 

Mat Cashman  

I’m good, Jeff. Thank you. I also go by MOT if you want to call me 

Jeff Praissman  

Like Mot, the Hoople. 

Mat Cashman  

Yes, exactly like Mot the Hoople, but not really. 

Jeff Praissman  

It’s always good to have you back in this nice warm February day here on the East Coast. And today we’re going to talk about something that is a pretty hot topic in the last year maybe a little bit more, but short duration options also like, Zero DTEs or zero days to expiration. 

Mat Cashman  

Yeah, for sure. I think it’s been longer than a year, Jeff. I’ve been talking about this stuff for a long time now, and I wanted to talk about it a little bit in a slightly different way than we, we usually approach this conversation. A lot of this conversation about short, dated options focuses on things like speed and leverage and gamma. 

And I’ve talked about that stuff on this podcast many times, right? And all of that Maters. But what tends to get a little overlooked in this discussion is structure, is the behind the scenes part of how these, these actual products and these options are designed and when expiration starts to compress and then become a regular cadence that happens in the market structure, really stops being a background thing and starts driving outcomes a little bit more and we want to talk about that today. 

Jeff Praissman  

This isn’t really a how to trade zero DTEs. It’s more about how they’re constructed and what sort of how they differentiate, I guess just by the pure amount of times that they’re going to expire versus regular expirations. 

Mat Cashman  

Yeah, absolutely. We’re not going to be talking about how to trade zero DTEs today. What I want to talk about is understanding what kind of option you’re trading, because when time gets really short, and sometimes, especially now, we have products that are going to look similar on the surface just because of their duration, but they can behave very differently at expiration depending on some of those. Parts of the back of how these things are structured, and people need to understand the differences there. 

Jeff Praissman  

And just to take a step back for our listeners, obviously back in the day equity options expired, that expiration once a month, then it moved to weeklies. And then obviously index options different, they move to Wednesdays, I think, and Mondays and Fridays now they’re, every day basically. 

And then also though. ETF options, which are more equity options, American style, which I I’ll let you explain to the listeners in a second. Started daily basically. And now as of I think it was January 26th, the NASDAQ listed, I think about nine or 10 equity options. So Mat, if you could kind of start just like the basics, like quick sentence on American versus European, why it matters, and then also, market kind of close market closes at four, but like, that’s not necessarily what we’re, that’s going to factor into our conversation. I don’t want to give too much away for the listeners. 

Mat Cashman  

Yeah. No, of course. Yeah, there’s a couple of there. As people say on podcasts very often, there’s a lot to unpack there. Right, Jeff? The first one, I want to respond directly to the what you asked for, which is the, essentially the difference between American and European style options. The biggest difference, and particularly the one we’re going to talk about today, is that American style options have the ability to be exercised early before they fully expire, right? That’s part of the way that American style options are designed and it always has been. It’s part of kind of just how they work. European style options can only be exercised at the moment of expiry, and so they expire and are exercised all at the same exact time. 

American style options have the potential to be exercised early. So that’s going to factor into our conversation pretty significantly as this goes on. But you also said something about, the market closing at four and that is technically, four PM Eastern. That is technically true. 

The stocks close around four PM Eastern. That part is true, but the lifecycle of these options, especially American style options. Don’t necessarily end at four PM So I think that’s something that I think we are going to talk about exclusively today. 

Jeff Praissman  

That’s a great point because there is a difference between the close of the market and then when there’ll be exercise and for our listeners that may not know this, there is automatic exercise process. If there, if your options are in the money they’ll generally, the system will generally handle it for you and obviously though, as the number of expirations increases this can become more and more important for your trading strategy. You could maybe walk through, like you can set and forget it and it gets exercised, but you can also send counter instructions to any of your brokers. 

I think it’s important to point out that while there is a standardized time that the OCC needs to get either the exercise notice or the contra don’t exercise this. There are a couple hands that have to touch it first, right, Mat? And that’s sort of why, and they can differ. 

It’s really important for listeners to check what their broker, what their cutoff, their specific cutoff time because it can vary slightly. And that’s something that you as an educated trader, you need to know. 

Mat Cashman  

Yeah, absolutely. And that I think is a big part of this conversation is that I’m trying to essentially advocate for people to understand as much of that as they possibly can, because essentially when you think about it, you’re as an end user of the product, your actual agreement is with your trading or brokerage firm. 

And so that agreement is what’s going to dictate like when you are and when you are not allowed to exercise or contra exercise those options. And so. The first thing I want to touch on is the difference that you mentioned, which is the auto ex process, right? That’s something, and it stands for auto exercise. 

Obviously, we shorten it to auto ex, but what that really means is that most of the time options are in the money and they reach a certain threshold of being in the money, which usually is 0.01 cent in the money. If the option is part of the auto ex process, it will be automatically exercised if it’s in the money and not exercised, if it’s out of the money. 

So that’s the way to set the table as far as what this looks like from the OCC perspective, that process covers a majority of options. If your option is one of those options that’s not part of the auto ex process, there is always an information memo that gets published and put on our website telling you that your option class is not part of auto ex, and if that is the case, you always need to decide whether or not you are exercising or not exercising that option. 

But those are usually edge case scenarios. That happens often in things like corporate actions or when the stock is halted and the options aren’t trading, something like that. And so, if that is happening, you should definitely reach out to your brokerage firm and find out what’s going on there and take a look at the information memos on the OCC’s website because they’ll be one if your options are out of auto ex. 

But most of the time, the assumption of auto ex holds true. Where things get interesting, right, is around this thing that we mentioned, the contra exercise window, and that’s the period after the close when an investor can provide instructions that differ from what the auto ex process would normally do, and that’s what we want to talk about today. 

Jeff Praissman  

Right and then it can go both ways, right? So, like if I’m short the option, I don’t have any control over it. And I don’t not, and if say it’s a 50 call and stock is going between, 49.98 and 50.05. I may not really know whether all of a sudden, I’m going to be short stock or not come the next day. 

And vice versa. Like if I’m long, long something and I am, whatever other, my positions may vary it may be advantageous for me to exercise it or not exercise it.  I have to make that decision too if it keeps kind of bouncing around. I think what we’re going to get in today is obviously that risk increases when you’re going from indices or I should say ETF options in this particular case to now these individual equity options that are going to, that are listed and for several reasons, which I know you’ll get into. 

Mat Cashman  

Yeah, absolutely. And the real crux of this is the difference between what I mentioned before an American style option and a European style option, right? That’s really what we want to drive home here. And this is the part I think that people often miss, and what you just said is very true, contra exercise, that window can cut both ways. It can be that you’re opting out of an automatic exercise of an option that is in the money, right? If an options in the money and it finishes in the money at four o’clock eastern time, you still have time to actually give what we call contra exercise. Advice through your brokerage firm and then through the clearing member firm to OCC to make sure that you don’t exercise that option if you so desire, if it’s an American style option. 

But it can also mean that you want to affirmatively exercise an option that technically finished out of the money. Right, like if you had an upside call and, in that situation, you were talking about stocks trading 49.95 and you own the 50 call, and then after the close the stock goes to 53 bucks, right? You are economically like it’s a good idea for you to exercise that option and that specific case. And so, in those situations you can also, when those economic situations change after hours. You can actually do that with an American style option, but you can’t do that with a European style option. That’s part of the reason why we’re talking about it, 

Jeff Praissman  

Yeah, and to be clear, there’s just nothing new as far as Zero DTEs versus weeklies versus monthlies. It’s just really more the cadence, right, it’s just a more frequent risk. 

Mat Cashman  

Yes, absolutely. And I talk about this a lot as previously when I’ve talked about Zero DTE options more broadly. This is like options have always, had some sort of Zero DTE quality to them. We just didn’t have a name for it like we do now. Options have always expired on their expiration day. What’s different now is the cadence of expiry. And so instead of having one. Major expiration event every month, which used to be the third Friday of every month. You touched on this at the beginning of our conversation, right? The cadence changed it, then it went to Monday, Wednesday, Friday in certain places, and then it went to Monday, Tuesday, Wednesday, Thursday, Friday. 

And so now what we have is a situation where you’re in many places, you’re seeing expiries every day. And so, the operational edge cases that used to show up occasionally, like what I was saying, right on the third Friday now are kind of a regular part of the regular rhythm of the market. And so, I think it’s important that we start to talk about that. 

Jeff Praissman  

So, it’s again, like I said it’s not new, it’s just more frequent. And people hear, Zero DTEs and they assume that the risk is basically the same, whether it’s an index or an ETF or single stock. But that’s not the case at all. 

And like, and especially now with these single stocks, like what are some risks that these single stock Zero DTEs have that, definitely the indices didn’t really have it. And even the ETFs are much more muted. 

Mat Cashman  

Absolutely. I think that’s really a core part of this discussion, and that’s where it’s worth being very explicit in this discussion. When you’re talking about something that’s a single stock, it has those kinds of idiosyncratic events, right? They have things that affect the stock specifically that wouldn’t necessarily affect the broader index. 

Now we’re in an environment where more of those broader indexes are made up of these cores, everyone’s talked about the magnificent seven over and over again. And so, it’s becoming more a part of the index, but you’re still dealing with something when you’re trading index options that you’re trading something that is more diversified than just an option on an individual name. Right? We could have things like corporate events that happen that only really affect this one stock and affect it in a very, and sometimes in a kind of like a binary way. And so that’s really where those edge cases have more risk built into them. When you’re talking about individual name Zero DTE options, it’s important to understand that and because of the fact that those options are American style options, like I said you have that early exercise potential where someone holds the ability to be able to exercise or not exercise that option within that specific window, and that’s going to make a big difference, right? Earnings announcements, guidance changes merger news, regulatory headlines, thinking, like, think about all those things, right? And they’re idiosyncratic to the name itself. 

Jeff Praissman  

Right. And with those single listed Zero DTEs, those risks aren’t able to really diversify away like an ETF or an index. 

Mat Cashman  

Exactly and when you’re dealing with index options, the diversification of the index kind of absorbs some of that, those idiosyncratic things, right? Because it’s a broader based thing. But in this case, if you’re dealing with a single stock name, it doesn’t do that. And so that’s really important to understand. It’s the whole outcome of that option, especially within that window. 

Jeff Praissman  

And why does that Mater more though for the Zero DTEs? Like if I own an Apple call that’s going to expire on Friday, like it’s still going to see those moves if it has those headlines that, on Tuesday or whatever, whenever they come out with earnings. 

Mat Cashman  

Absolutely it, the reason it matters is because there’s no time buffer left, right? It’s not a 90-day option where you have 89 more iterations of price movement. In order to decide whether or not you want to exercise the option, it’s right now, it’s a zero day to expiration situation and in something that’s like an afterhours earnings move, you’re not reassessing it necessarily tomorrow. It’s an, it’s immediately relevant to what that option is worth and like how much you can make or lose depending on whether you exercise or don’t exercise. And so that’s why it matters with these because the time duration is shortened. 

Jeff Praissman  

Right. So, you don’t get a second or third or a fourth or a fifth trading session to get to see what happens with the underlying. 

Mat Cashman  

Exactly, yeah. In longer dated options, right? The overnight move is something that you can digest and think about and be like, oh, does this change my, my overall look as to what this is, what my time horizon is, or whatever. In this case, right? The Zero DTE spot, it is the expiration. It’s the event. And so, it’s important to understand that. 

Jeff Praissman  

So where do ETFs fit in this? 

Mat Cashman  

ETFs kind of sit somewhere in the middle, right? It’s, they’re diversified, but they still trade like equities, and technically they are equities. They still have after hours movement. They still hold underlying components that can be affected by sector specific news. And so, they’re kind of, they’re gray areas. I would say that’s in the middle. 

Jeff Praissman  

And what about index options? I think a lot of people might confuse ETFs and indexes sometimes, right? Like they’ll see SPY and confuse it for SPX, but they are very different, right? 

Mat Cashman  

Yeah, absolutely. Index options, like I said, for the most part, are predominantly European style cash settled options, and so that essentially, for lack of a better term, it strips a lot of this away as far as additional risks, there’s no early exercise, which also means there’s no contra exercise window, there’s no delivery of the physical underlying, because in many cases you’re talking about an option that’s trading on an index that actually doesn’t have a physical underlying, right? It’s that the underlying is this thing that’s made up of all the prices of the individual components of it, and so the settlement of that whole situation is very formulaic. And I think also you need to think about the fact that many times people have adopted those options in that way over time because of that reason, because of the fact that they don’t have to deal with the early exercise idea or the risks that are commensurate with that, dealing with the individual stock options. That’s part of the reason why people have, if you ask in institutional investors why they trade, like index options. Part of the reason is they want the diversification, but the other part of it is like I want to trade something that’s a European style option, so I don’t have to worry about whether or not it’s getting exercised early. And that’s, that’s a part of the way that risk is set up for those options. 

Jeff Praissman  

So, a lot fewer chances something unexpected could show up, late, especially later. 

Mat Cashman  

Yeah. Absolutely. And that, right, that doesn’t make sense. That doesn’t make index Zero DTE options low risk. It just means that the expiration mechanics of it are cleaner. They still have lots of other risks that are associated with it. But the end point, right? That time at four PM Eastern Time is different for that option than it is for an American style 

Jeff Praissman  

Right, which matters more, especially the shorter the duration gets. 

Mat Cashman  

Yes, absolutely. And that, I also think that’s one of the reasons why those Zero DT option products scaled so quickly in the European style options, because the finish line is just simpler, just like I just said, right? Those institutional investors that choose those options for that reason. That kind of thinking about those options has been really prevalent in the adoption of those options also along the way that we’ve seen. 

Jeff Praissman  

Mat, what do you think people misunderstand the most with these Zero DTEs? 

Mat Cashman  

Well right now I think, and we haven’t seen this yet, right, we’re super early in the listing of these Mondays and Wednesdays on single stock names that are American style options. And so, I don’t want to like, sound any alarm bells or anything that’s not what I’m trying to do here. What I’m trying to pinpoint for people, is that I think one of the risks that might be on the horizon is that people are assuming that the mechanics of these are standardized because the symbols and the duration looks standardized, but the variability isn’t in the options contract, it’s in how the expiration process is handled like in an operational way and so that part is a little bit more opaque. It’s a little harder to understand, you have to go and dig kind of one level back and see like, okay, what are the contract specs of this? Is this an American style option or a European style option? And then you have to think about that time window. The auto ex process and all of those things when you’re dealing with American style options, but from the outside, especially if you’re just looking at it from a duration perspective, you might think like, oh, this is just a Zero DTE option, just like anything else, and not do that digging. What I’m encouraging people to do is do the digging to figure that out, because that’s where this matters. 

Jeff Praissman  

And you want people to assume something and all of a sudden, the opposite happens and they’re like, wait a second, I thought this was going to happen and that happens instead. 

Mat Cashman  

Yes, and we get, we get email questions about that already on our investor education desk and that’s just in, right, like options that are in individual stocks that have come to expiration and it’s on Fridays or whatever. And so now, right, the way I look at it, and I have to look at this and think like, okay, like how many more people are going to be emailing us with situations like that asking for an explanation is how this happens, and the answer is most likely, there’s going to be a lot more people talking about it and asking questions and things of that nature. So, part of my job as an educator is to get ahead of that and say like, listen, think about what this is, think about whether or not this option looks comfortably in the money or out of the money and whether or not it’s American or European style before you start, just like doing the set it and forget it vibe, right? 

Jeff Praissman  

Mat this has been great as always. Love having you come in, talk about options. Are there any final thoughts you want to leave our listeners with? I think you really covered a lot with the Zero DTEs, especially this, the new kind of additional risk added on for, individual equities. Again, we don’t want to discourage anyone we, from doing, trading or anything. We just want to make sure that everyone’s educated on potential risk and, knowing what they’re getting into before they get into it, 

Mat Cashman  

Yes, absolutely. I mean, I think that’s really the crux of the whole thing. My job as an educator is not to tell people, not to trade short-dated options. Obviously, my job is to make sure that people understand what they’re trading before they trade it or like when they’re trading it and help them to understand what that means. 

It’s don’t not trade short-dated options, it’s know what can move the stock and know particularly when your decision-making window ends because in this case it can be different from brokerage to brokerage and trading firm to trading firm and so make sure you understand what that cutoff time is. It’s a big deal. And right now, when we’re dealing with the transition into having zero DTE options that are moving into American style single names, it’s going to be something that’s going to show up on people’s radar because of the cadence of these expirations, right? We used to deal with it every third Friday, and now we’re going to be dealing with it every, like Monday and Wednesday in certain names and things of that nature. 

And you can expect them to I, like when these things get listed, they generally expand as far as like, people like to use them, and I want people to use them for the intended purposes, but I want them to understand the limitations and the actual, the contract specs of what they’re trading. 

Jeff Praissman  

Mat, thanks again for stopping by the studio. For our listeners, to get more from Mat, you can go to occ.com, you can go to IBKR.com, click on education. You can see all our past webinars and podcasts that we do and again, thanks, thanks for stopping by. 

Mat Cashman  

Absolutely. Thanks for having me. If you want more information about options education from the OIC, you can also go to options education.org.