The rise of options trading among average Americans during and since the pandemic has been hailed as a welcome introduction to the markets for newbies.
It is not. It has been an unmitigated disaster for the benefit of three companies and billions of dollars.
Small options trading grew 224% from the end of 2019 to mid-2021. That was during a time when stocks plunged, then soared, and the media relentlessly covered meme stocks and the outsized profits of ” beach bums” as Mike McCaskill.
Anecdotes are not data, and data is impressive.
Coinciding with the dispatch of stimulus payments in mid-2020, smaller options trades exploded relative to total volume. From 2002 to 2019, small traders accounted for 15-20% of all options volume. From mid-2020 to today, that share has doubled.
During most of this period, retail options traders lost $1.1 billion on their trades. That’s where some of the $817 billion in stimulus checks went: They went up in short-term call options.
Call it what it is: Gambling
During the explosion in trading volume, small traders were buying call options at the money or slightly out of the money. Only about 4% of the volume was concentrated in deep-in-the-money options, which can deliver tighter spreads on liquid stocks.
As stocks surged following the pandemic panic, traders spent 69% of their volume on calls. Most notably, around 50% of all trades expired in less than a week. Stocks had to rally immediately and significantly to overcome the effects of trading costs, commissions and time decline. It was pure gaming and was especially heavy on meme stock, including GameStop GME,
and AMC AMC,
Hhidden role of ignorance
When you buy an option to open, you have to pay the asking price, unless you place a limit order (which retail investors don’t usually do) or you are lucky to have a broker who offers you a better price. From November 2019 to June 2021, retail traders lost more than $4.1 billion due to trading costs including bid-ask spreads like these.
In those trades, the bid-ask spread reached 12%. That is an immediate loss if an investor tries to turn around and sell the option at the offer price.
It was even worse for out-of-the-money options, which accounted for about 24% of the volume. Those spreads averaged a whopping 28%. About 14% of trades were “micro” in size, for $250 or less, so up to an instant loss of $59.
The gamification of options trading means that some of the built-in losses were hidden, or at least not properly revealed. Most of the platforms highlighted their free commissions, failing to point out that traders faced immediate and substantial losses on every trade.
While some brokerages offer commission-free trading, others do not. During that period from November 2019 to June 2021, retail traders lost another $800 million in commissions alone.
GRAMIt’s for Wall Street
Being new to the options market, many traders who bought call options at the money did not exercise them before their ex-dividend dates. As such, they were not entitled to dividend payments.
Maybe it was just laziness, but we’ll give them the benefit of the doubt. This is a pretty esoteric process, and who wants to think about boring dividends when GME is skyrocketing?
When call option holders do not exercise their dividends optimally, option writers can receive windfall profits. Which some did.
On the other side of these exchanges were three firms to the exclusion of almost all others: Citadel Securities, Susquehanna, and Wolverine. Companies accounted for 85% of the payout of order flow in the options market, thanks in large part to the large trade flows coming from Robinhood HOOD,
What can be done?
There is no single solution that regulators can pass along to fix all problems. The main reasons for the losses were due to fundamental human errors: greed and ignorance.
Still, brokerage firms that offer options trading to retail investors could more clearly express the cost of trading options, including bid-ask spreads.
If a trader enters a buy order for an option that expires in a week or two, companies could create or improve risk disclosures that highlight the high probability of loss.
For traders who currently hold call options at the money, brokerages are required to send alerts directing the option holder to exercise their options before the ex-dividend dates.
(Note: Most of the data in this article comes from a revealing paper by Bryzgalova, Pavlova, and Sikorskaya published in April 2022.)
Jason Goepfert is founder and director of research at Sundial Capital Research, a Minneapolis-based research firm.