By Svetlana Bryzgalova, Assistant Professor of Finance; Anna Pavlova, Professor of Finance, and Taisiya Sikorskaya, PhD Candidate in Finance, London Business School
As the pandemic surged, many were drawn to the markets, and options. Use of smart phone investing and apps like Robinhood increased, given ease-of-use and promise of commission-free trading. 21.3 million monthly active users flocked to Robinhood alone in late 2021, according to company statements. The world watched in fascination as GameStop stock spiked to over $80 a share in January 2021, rallied by WallStreetBets and others on Reddit. A new generation of young, tech-savvy retail investors was underway.
Some predicted interest in meme stocks and options would wane. However, we have seen periodic surges in AMC, Bed Bath & Beyond, and others since, and an increase in retail trading in options overall.
We have all seen or heard stories of people posting about major gains in options for meme stocks on Reddit. But how do most retail traders actually fare when it comes to investing in options? In academia and society overall, little is known about what retail investors do in the options market, and if they realize the risks of trading with these more complex instruments.
One concern expressed by the SEC and others surrounds the use of payment for order flow (PFOF), or the transfer retail brokerages receive from wholesalers for executing trades on their behalf. In equities, wholesalers cross this order flow on their private trading platforms, away from national exchanges, which prevents healthy competition from other market makers for them. Some also speculate on whether PFOF may lead to wider bid-ask spreads on exchanges and/or potentially incentivize investors to trade more.
These were some of the considerations that fascinated us as we undertook our research, “Retail Trading in Options and the Rise of the Big Three Wholesalers.” We would continue to be surprised about the findings when it comes to the volume of retail trading in options, motivations of traders and their losses, along with other benefactors of this trading.
The Data Behind What Retail Investors Do in Options
What are our findings, and how did we arrive at them? In the first part of our paper, we measure retail trading in options to document the rapid increases in retail activity in this market. We consolidated transaction level data from US exchanges from OPRA and historical options data from OptionMetrics, the gold-standard and most used options database.
We classified trades most likely to have been intermediated by wholesalers, such as Citadel Securities, Susquehanna, and Wolverine. These formed the basis of our measure of retail options trading. For performance, we aggregated transactions from retail investors. We examined our measure against, and showed that it comoves with, equity-based retail popularity proxies – for example, mentions on WallStreetBets – and drops significantly during U.S. brokerage platform outages and trading restrictions.
We examined trades from November 4, 2019 until June 31, 2021, a period which focused on the pandemic, and found that retail investors trade a lot. We hand-collected SEC (Securities and Exchange Commission) Rule 606 forms and inferred from them that 48% of the total market trading volume is retail. Our measure captured a large fraction of this volume.
We found that the growth in the retail trading volume mimics the growth in PFOF (based on SEC Rule 606 reports from broker web sites). PFOF from options has become quite significant and, as we have discovered, is much higher than from equities. In 2021 alone, $2.5B was received from wholesalers by retail brokers as payment for order flow from options. This is almost double the $1.3B in PFOF collected from equities.
This opened up the door for many questions: What contacts do retail traders like? What are their strategies? Are they using options for hedging or betting? How do they do financially?
In our second contribution, we examined what retail investors do. We analyzed specific features of trades – short-term, long-term, direction (buy or sell) – along with greeks, open interest, and other factors, using data from OptionMetrics for comparative analysis.
Retail Traders Bet Big
We discovered that retail investors are very much focused on cheaper, weekly, or short-term (versus long-term) options, with very high embedded leverage in them. They appear to prefer options with very short maturities and primarily calls. As such, they tend to use options for speculation or betting purposes over hedging, and often purchase contracts where they lose a lot of money. We estimated that since the start of the pandemic, retail investors have lost more than $2B on options trading.
The focus on buying these risky, short term contracts is a major reason for their losses. While there is the potential to win big, given betted leverage, the chances of winning are very low, given these factors, similar to buying a lottery ticket to participate in this gamble.
Large trading costs also play a part in retail trader losses. Since Robinhood and commission-free trading, options trading has been on the rise. As retail traders do not have to pay to execute trades on these platforms, it may appear as though trading is free. However, this assumption is flawed. While retail investors don’t pay a commission, they are required to pay the bid/ask spread. Option contracts overall are less liquid, of course, than purchasing the underlying equity. This lower liquidity contributes to options having higher bid/ask spreads, and retail investors tend to choose those with higher bid/ask spreads overall. As they favor contracts with high relative bid/ask spreads, the fees tend to be very high. The average bid/ask spread in options most popular with retail investors is a whopping 12.6%.
We liken retail option trading behavior to using the exchange booth in an airport. These booths may charge zero commission to trade currencies, but the exchange rate is often so unfavorable that it does not make sense to use them.
We also found that the biggest losses, by retailers are relative to what the market has done. For example, we found that trades from retailers in options in GME and AMC in our sample were in the top 7 losers, while trades in GME and AMC provided the highest gains to the rest of the market participants during this same time period.
Finally, we discovered that retail investors often do not optimally exercise options. For instance, it might be good to exercise an option contract on certain dates, such as right before the underlying company pays out a dividend. Yet our research indicates, in this and other behaviors, the majority of retail investors do not appear to price options or use common models.
Findings and Takeaways
What can retail traders and investors learn from our findings overall?
Trading options is much more popular with retail investors than many may think. Participation in this market is growing, with many retail investors using options for betting rather than hedging.
While retail investors may be drawn to stories of major gains in options trading on Reddit and others, these examples are few and far between in the market. For the majority of retail traders in options, most tend to select short-term contracts with large bid/ask spreads and transaction fees that are often bound to lose.
This opens up many questions:
Is there a need for greater investor protection when it comes to retail traders and these complex investments? With options, unlike with equities, there is no passive long-term rate of return or market risk premium.
What drives retail investors’ particular choice of short-term option contracts over other types of contracts? Could gamified smartphone trading platforms encourage investors to trade more or to trade particular contracts?
PFOF has drawn criticism given possible adverse incentives such as, potentially, obfuscating the costs of trading and/or having the potential to incentivize brokers to encourage trading. The SEC is currently examining this compensation method.
What should the minimum knowledge be for people to invest in options? Should platforms provide access to auto reminders, calculators, models, or other tools to help retail investors avoid leaving money on the table?
To this day, much is still not known in the financial industry and academia about retail investor behavior in options. While even a few years ago financial researchers and market participants could ignore this crowd, the presence of retail options traders has grown. Our paper calls for more research in this space and considerations for greater transparency in reporting in retail options, as with current requirements by FINRA in equities. With so much still unknown about retail options traders, we see numerous opportunities to learn even more about this new breed of investors.
