Zero-day options are getting popular with retail investors. You should stay away

Published Fri, Sep 15 20236:00 AM EDT

The stock market can be many things. It can be a vehicle for investing in your future by building wealth slowly over time in a disciplined way. It can provide opportunities to speculate on the outcomes of events or on winners and losers in different industries. It can also be a magnet for gamblers, who view it as the world's biggest casino with an endless supply of bets to make and riches to win. We obviously believe the "building wealth slowly" option is the best use case for stocks. After all, the longer the investment horizon, the lower the risk. Long-term investors can ride out a bad headline or quarter, or a misstep by management. We're not totally opposed to the "opportunities to speculate" option, so long as the investor understands the risk and reward of speculating. As the saying on Wall Street goes: "Your first loss is your best loss." That means if you get the trade wrong, you should take the small loss and move on. Don't throw more money at a hunch, even if it's backed with some research. We hate the "world's biggest casino" option. Gamblers give the market a bad name. Most investors who attempt high-risk, high-reward investments end up leaving the market with less money and a bad taste in their mouths. It also prevents them from coming back to the world's greatest wealth-building vehicle the right way. There was a lot of gambling on stocks during the Covid pandemic. Much of the world was shut down, including actual brick-and-mortar casinos, and there were few sporting events to bet on. However, the stock market stayed open. And thanks to mobile devices, commission-free brokers, stimulus checks and extra time on peoples' hands, stock trading took off. Social media forums like Clubhouse, Twitter Spaces and Reddit were filled with retail investors pitching stocks and investing strategies like memes. As a result, retail investors' share of stock trading volume reached 24% in the first quarter of 2021, up from 20% in 2020 and just 10% to 15% for the preceding decade, according to Bloomberg Intelligence. That excitement has since cooled a bit. The day-to-day volatility in stocks settled as the world reopened and most people got back to work. But the gamblers still wanted to play and needed some new action. Enter the 0DTE, or "zero days to expiration" options. Just what are these futuristic-sounding investments? They are option contracts like any other, only they expire on the same day they are purchased. If that sounds risky — or nuts even — that's because it most certainly is. We don't usually talk about options. It's not an area of the market we play in. However, the prevalence of these 0DTE options has become too big to ignore. In fact, trading in 0DTEs has exploded to more than 40% of the total SPX options volume this year, up from just 5% in 2016. This summer, that share grew even more to an average of 50% in August. As with the meme stock frenzy, stories of traders making lots of money have likely driven that growth. Easy access to options trading online certainly helped, too. And then there's the thrill that comes with this kind of trading. A move of a few percentage points in the underlying stock can amount to a double- or triple-digit percentage point increase in the options market. Big swings in a tight timeframe — ideal for gamblers. It can mean a huge loss. It's one of the worst "investing" ideas out there. For starters, the maximum amount of time you have for some stock action to take place is the length of the regular trading day, or 6½ hours. Options don't trade during extended hours. In other words, if your option isn't "in the money" by the closing bell, it's worth nothing. What is an option contract? First, some basics: An option contract is something investors can buy from a counterparty, through their brokerage, that gives them "the right, but not the obligation" to buy or sell a given security at a certain price, called the "strike price," and by a certain date, called the "expiration date." The contract is between two investors. The buyer of a call option is betting that the underlying stock will go higher, whereas the buyer of a put option is betting that the underlying stock will go down. The "premium" is what the buyer pays upfront for the option contract. Options contracts, which always represent the rights to 100 shares of the underlying stock, can be winners, or they can completely blow up in your face and wipe out your account's value. Call options Here's an example. John thinks that Apple (AAPL) stock is going to move higher over the next month. The Club stock is currently trading at $180 and he predicts it will exceed $185 within 30 days from now. Rather than buy 100 shares of Apple at $180 each, which would cost $18,000, John decides to use an options contract. This allows him to benefit if he is correct without putting up all that capital upfront. He looks at the "option chain," where all available contacts are listed, and buys a call option contract with the following characteristics: Days to expiration: 30 days Strike price: $183 (to buy shares) Ask (the premium): $2 per share (or $200 total representing 100 shares) John now has the right (but no obligation) to buy 100 shares of Apple at $183 per share within the next 30 days. For this right, he will pay the $2 per share (or $200 per contract) upfront. In this scenario, the most he can lose is his premium, or $200. John's break-even price is $185 (see chart below). Why then would John want this contract that could put him out of $200? First, by purchasing the contract he doesn't have to tie up $18,000 (100 shares at $180 apiece); he only ties up $200 (the premium) and gets the rights to all the upside past the $183 strike. There is also a lot of leverage built into options contracts — getting the upside on an $18,300 position for $200 — and in the case of a straightforward call option such as this, there is no need to borrow on margin (which brings its own set of risks). Once John breaks above the strike price of $183, his contract is considered "in the money" as it has some real value, even if it won't fully cover his cost until he hits the $185 break-even level. Here's where leverage comes into play. If he had just bought the Apple stock at $180 and shares rose to $187, John would see a 3.9% return. However, since he has the options contract, John would make 100% on his money with that move because the contract he paid $2 per share for is now worth $4 per share (the amount above the strike price of $183). So, for $200 upfront, John now has the right to buy 100 shares of a $187 stock for the price of $183. Put options A put works in the opposite way of a call. Instead of buying the right to purchase shares, investors have the right to sell shares at a given strike price by a given date. John would do this if he thought the shares of Apple are going to fall in the next month. (It's kind of like shorting, or betting against, a stock except you don't have to borrow the shares upfront). Let's use the strike price of $183 again and a $2 premium. Once Apple shares fall below $183, John is "in the money" as he can buy shares under the $183 strike level in the open market and sell them to the person who sold him the put option at $183 apiece. In this instance, our breakeven is $181 per share because if John buys in the open market at $181 and sells them to the option counterparty at $183, he makes $2 per share, just enough to cover the upfront cost of the contract. If shares were to go to $179, then he would make the same 100% profit as in the call option example. The profit profile of a put mirrors that of a call (see below). 0DTE options are insanely risky Options are already a risky investment, but 0DTE are on another level. We understand that the longer the time horizon, the lower the risk. The inverse is equally true: the shorter the time horizon, the greater the risk. A timeframe of hours gives investors no time to ride out a bad headline or just overall sluggishness in the market. As a result, this is gambling, not investing. Unlike the examples from above, the strike price has to happen in one trading day instead of 30 days. You're losing money until you hit the break-even price. The 0DTE is compressing all those variables down to those 6½ hours. These are bets on daily moves that will likely have nothing to do with the stock's underlying fundamentals or value. And you need a big move, which usually happens overnight and not during regular trading hours, which is the timeframe we're talking about for the 0DTE — from the opening bell on Wall Street at 9:30 a.m. ET to the close at 4 p.m ET as mentioned earlier. This is also a highly competitive, fast-paced market you're, with sophisticated market makers and institutional traders with better data than you. When people talk about how professional traders armed with sophisticated algorithms can't be beaten, they are talking about the people who are going to be on the other side of the trade from you on these almost comical devices. Trust us, you aren't getting over on anyone if you think you're getting a good deal on these. You may nail one or two bets, but it's really dumb luck. You're better off investing over a long term through exchange-traded funds (ETFs) or individual stocks of companies you've done the homework on. We have heard the shameful marketers of these products come on and tell you how they are fulfilling your needs, that they are giving you what you want. They aren't. They are trying to make their quarter just like everyone else and they invented something that will give them better bonuses at your expense. They want to take you to the cleaners for some extra change, grateful that someone thought of this nonsense. They should just tell the truth and say, "These options fulfill no use other than to make us money all of the time and lose money most of the time. Enjoy, suckers!" Do yourself a favor: If you want to play those odds — gamble instead. Go have some fun in Las Vegas. At least there you get some comps when the house takes your money. (See here for a full list of the stocks in Jim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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It can also be a magnet for gamblers, who view it as the world's biggest casino with an endless supply of bets to make and riches to win.

We obviously believe the "building wealth slowly" option is the best use case for stocks. After all, the longer the investment horizon, the lower the risk. Long-term investors can ride out a bad headline or quarter, or a misstep by management. We're not totally opposed to the "opportunities to speculate" option, so long as the investor understands the risk and reward of speculating. As the saying on Wall Street goes: "Your first loss is your best loss." That means if you get the trade wrong, you should take the small loss and move on. Don't throw more money at a hunch, even if it's backed with some research.