A guide to find profitable 0DTE trades

Just not where you think they are.

Finally, volatility has spiked - the biggest intraday move since November 2021.

Long volatility traders are dusting off their "I told you so" mantles, while some who bet heavily on the short side might be licking their wounds.

In the realm of short volatility trading, days like yesterday are part of the game. Your goal is to manage risks as best as possible to avoid getting burnt: control your gamma exposure and try not to stay there too long, particularly ahead of potential market catalysts.

At the end of the day, it always comes down to a fundamental question: what is your role in the marketplace?

At its heart, short volatility trading is akin to the insurance business. You're essentially offering short-term protection to fund managers wary of their long-term performance. You are dealing with the risk they don’t want, and in exchange, they pay for the service.

Once in a while, there comes an incident, and you have to cover the bill.

It’s called business.

To be honest, we are quite excited about that spike; it means fund managers may wake up after four months of euphoria. Yes, the market can move 2% in a day, and when it does, you’d better be covered. Hopefully, this will serve as a reminder and prompt their swift return to the options pit. And if you know how to assess risks, you can take advantage of their price urgency and price insensitivity.

Ultimately, the essence lies in evaluating situations for what they truly represent.

For instance - why would you buy the volatility in us equities right now, right after the spike?

It may be tempting but not opportune. Volatility does mean revert. And we don’t know - nor is it that important - if it is on its way to 19.

Therefore, avoid buying puts with no other plan than “VIX was up 25% at some point yesterday and then closed under 16. Therefore, it’s a good point of entry, and it should go back to a reasonable level, real fast, real soon.”

What’s a reasonable level? Something you guessed through lines and resistance on a chart? Or a piece of insight you read about dealers’ gamma exposure? No one knows what a reasonable level is, and the most reasonable thing to do is to stay calm and patient.

Let the VIX rise, and when it is ripped for being short, you’ll get the memo soon enough. It is an easier trade than timing spikes like yesterday.

So, what's the move in the meantime?

We stick to our proven strategy: seek out areas where the market's compensation exceeds the risk. The financial world extends far beyond U.S. borders, and while global markets often move in tandem, each has its unique risk perceptions and motivations for purchasing insurance.

Given the positive feedback on our recent VXX trade, we're diving into 0/1DTE for two emerging market ETFs: EWZ is tracking the Brazilian equities, while TUR is doing the same for Turkey.

These ETFs represent vibrant yet fluctuating economies, each with its unique set of challenges and opportunities for short volatility traders.

In the mind of a fund manager

For once, let’s reverse roles: you just step into the shoes of a fund manager with a mandate to deploy capital in international markets, specifically in Turkey and Brazil.

Needless to say, this part of the job may be a bit more colorful than investing in Sweden and Germany, two other important lines from our portfolio.

As respectable fund managers, we assume we did our homework and understand the ins and outs of the Brazilian and Turkish economies. It’s precisely for this reason that we feel a little uneasy. No offense to our readers from Turkey and Brazil, but the local situation is often more volatile than in Sweden and Germany.

At Sharpe Two, we avoid making calls on economic and political situations. However, we will look at the market like fund managers do, just for the next two paragraphs.

The super low rate policy of Erdogan when inflation was at a record high was, at the very least, questionable and has destroyed a lot of value and slowed down many vital parts of the economy. The same goes for Brazil: two of their last three presidents ended up in jail for corruption, and the one who didn’t go … may very well go at some point in the near future.

Political uncertainty has always had a great influence on the economic strength of these countries, unfortunately. And while everyone recognizes the enormous potential, it fails to materialize, which in return undermines confidence in foreign investments. Meaning us, the respectful fund managers.

Let’s make it even more concrete. In early January, you were told that your bonus depends exclusively on how well your position in EWZ and TUR performs. Wouldn't you feel even more nervous?

We would, for sure. And to make sure we don’t end up with nothing because of events unfolding miles away from our desk and completely outside of our control, we will .. turn to the options market to hedge immediately for 66 million of EWZ and 33 million of TUR.

A side note - The only reason why we picked these numbers was because Brazil beat Turkey 1-0 in the semi-final of the 2002 World Cup. It is not a reflection of Sharpe Two preference for one against the other. Anyway, this publication is for information purposes only: get in touch with a financial advisor if you want advice on the market.

Not the biggest positions ever, but no small change either — just enough to create some interesting price distortion in the options market.

Fund managers know all too well that the situation in these countries can seriously deteriorate overnight, and therefore, they need to buy insurance. They also tend not to negotiate on price.

Why would they? If the volatile Erdogan announced he would join Putin in its war against Ukraine, how would you write these 33 million on TUR in your next investment report? If you are looking for inspiration, think about how Russian assets plummeted in April 2022; if you get a penny on the dollar, you will get lucky. Better safe than sorry - so don’t negotiate; bid them puts as if your life bonus depends on it, and tip your broker for the service.

Follow the money

Let's refine this analysis with the data. We're going to examine the returns from selling straddles in both ETFs at varying days to expiration (DTE). To ensure consistency and account for non-trading days, we'll use business days to expiration as our standard measurement.

We're specifically looking at the profitability of selling a straddle one business day to expiration (1 bdte), five bdte, and ten bdte, while holding until expiration.

The last three days until expiration allow you to capture most of the premium without hedging.

The findings for the Brazilian ETF (EWZ) are quite revealing. Interestingly, selling a straddle ten business days to expiration yields, on average, the same return as selling it just three days before expiration. This pattern underscores fund managers' habit of seeking last-minute hedges—opting for what they perceive as cost-effective protection against unforeseen market turmoils. The mantra "better safe than sorry" seems to prevail.

For TUR, the Turkish ETF, the impact is even more substantial. Yet, it's important to note that TUR's market is significantly less liquid than EWZ's, with only monthly contracts available, not weekly. This discrepancy in liquidity might explain some of the observed differences in trading behavior and outcomes.

Setting aside the liquidity differences, the pronounced outperformance on days 10, 9, and 8 compared to days 6 and 7 underscores the predictability of fund managers' behavior. Imagine you're a fund manager with compliance policies mandating hedging. This often translates into a pattern of securing protection right before the weekend (10 bdte translating to 14 dte) or early in the week preceding expiration (9 bdte or eight bdte). Otherwise, you will focus on the last few days before expiration, where the premium is the lowest … but not the cheapest.

While averages provide insights, the true story unfolds in the cumulative P&L returns.

Selling 1 day ahead is as profitable as selling it 10 days before in EWZ.

It's noteworthy that positions opened 0 and 1 business day to expiration (bdte) yield comparable results to those initiated two weeks prior. This observation reaffirms the strategic timing of fund managers seeking to hedge.

The Brazilian ETF, EWZ, remains a favored asset for us, consistently offering clear advantages, especially in short tenures. TUR, the Turkish ETF, presents a different scenario. Although it offers potential in the very short term, concerns over liquidity and geopolitical proximity to conflict areas prompt us to exercise caution across other parts of the expiration cycle.

Because it is a monthly contract, you have less opportunity in TUR. Yet the 1 day still overperforms the rest.

It's important to acknowledge the inherent risks in these markets. They often come with a set of challenges, including the potential for sudden political or economic shifts, which explains why the premium. It also means that once in a while, things can turn bitter.

The Brazilian ETF's performance dip from April to September 2022 wasn't just a reaction to the Fed's interest rate hikes; it also reflected investor nerves around the turbulent management of the COVID crisis and the buildup to the presidential election. In such times, the trading edge becomes murky, with one notable exception: trades placed one business day before expiration (1 bdte).

The trade methodology

So, what's the trading strategy?

Consider shorting the ATM straddle in EWZ and TUR one day before their expiration. For those feeling a bit more daring, you might start shorting EWZ two weeks in advance. However, we advise caution with TUR due to its unique set of risks.

The appeal of this strategy lies in its simplicity. For once, you can temporarily set aside the Variance Risk Premium (VRP) and focus on a more tangible indicator: media attention. Are these countries currently making headlines? If yes, it might be wise to steer clear of selling those insurance contracts. But in quieter times, like now, it could be an opportune moment.

What we also like is the rapid return on capital. You can put the trade on one day before the expiration and have your margin available at the close the next day.

However, always keep your position sizes within reasonable bounds. Every so often, unexpected events will trigger market volatility, and as the insurer, you'll be on the hook for the costs.

Be sure to follow us on Twitter @Sharpe__Two for more of our insights. If our work resonates with you, don't hesitate to share it with others who might find it helpful.

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Disclaimer: The information provided is solely informational and should not be considered financial advice. Before selling straddles, be aware that you risk the total loss of your investment. Our services might not be appropriate for every investor. We strongly recommend consulting with an independent financial advisor if you're uncertain about an investment's suitability.