Academic research, including the 2015 study Does Realized Skewness Predict the Cross-Section of Equity Returns and the 2019 study Cross-Asset Skew, has found strong evidence of a negative relationship between realized skewness and future stock returns — as you would expect, because most investors are risk averse, stocks with negative skewness (a chance of a large loss) are associated with higher expected returns. However, as skewness increases and becomes positive, the positive relation between volatility and returns becomes a negative relation—investors may accept low returns and high volatility because they are attracted to high positive skewness. This has been referred to as the “lottery effect” — investors have a preference for assets with lottery-like distributions (large chance of a negative outcome, but small chance of an extreme positive outcome).
Attracted by the low nominal price of options (providing leverage) and their lottery-like potential outcomes, along with the recent practice of charging zero commissions — payment for order flow (PFOF), whereby the market makers to whom a brokerage firm routes its orders for execution pay for the orders they receive, was pioneered by the mobile app Robinhood in 2015—trading in options by retail investors has exploded. Note that PFOF creates an incentive for brokerages to encourage investors to trade more, and to trade assets with larger spreads (the opportunity to trade options is displayed prominently on gamified investing apps used by the new generation of investors)—likely to the detriment of investors.
In just the second quarter of 2021, brokerages in the U.S. received $581.2 in PFOF.
Svetlana Bryzgalova, Anna Pavlova and Taisiya Sikorskaya, authors of the April 2022 study Retail Trading in Options and the Rise of the Big Three Wholesalers, analyzed the options trading of retail investors and its profitability. Their data covered all trades on 16 U.S. exchanges in index, exchange-traded fund (ETF) and equity options, focusing on ETF and equity options and excluding index options. The sample period was October 2019-June 2021. Following is a summary of their findings:
There has been a significant increase in retail investor trading in options, as measured by both wholesaler trades and small trades on options exchanges — the dollar trading volume in options grew by 143 percent from November 2019 to July 2021.
Despite the average quoted bid-ask spread of options on stocks in the S&P 500 being dramatically higher (as high as 17.2 percent) than the bid-offer spread on stocks, retail traders prefer options, especially cheaper weekly options (“cheapest” alternative does not mean cheapest to trade) — 50 percent of wholesaler trades were in short-term options with less than a week to expiration, with an average quoted bid-ask spread of 12.3 percent.
Retail investors strongly prefer call options to puts (the volume share in calls was 69 percent); they trade mostly at-the-money (72 percent of trades) or slightly-out-of-the-money (24 percent of trades) options; and they prefer options in stocks whose underlying price is lower (which involve higher trading costs, with the average quoted bid-ask spread of 28 percent).
Retail trades had a microsize of up to $250, and their average quoted bid-ask spread was 23.4 percent.
Retail options trading was positively correlated with stock-based measures of retail activity, such as ticker mentions on the WallStreetBets forum and Robinhood ownership breadth—evidence of speculative rather than hedging motives behind their trades.
There were significant increases in both call and put net purchases during retail investor frenzies (such as in the January 2021 GameStop episode), especially in trades of a smaller size.
Retail trades through wholesalers were unprofitable over the one-, two-, five- and 10- day horizons examined.
Retail investors are less likely to exercise their options optimally, failing to exercise them prior to the ex-dividend date (when exercising an option on a cum-dividend date and collecting a dividend exceeds the value of the call the next day, when the stock goes ex-dividend).
From November 2019 through June 2021, after trading costs, retail trades lost more than $4 billion!
An inflow of inexperienced retail investors has boosted profitability for wholesalers, allowing for the PFOF that incentivises the promotion of the trading and for the commission-free trading that encourages it.
Bryzgalova, Pavlova and Sikorskaya’s findings are consistent with those of Rob Bauer, Mathijs Cosemans and Piet Eichholtz, authors of the 2015 study Option Trading and Individual Investor Performance, who found that retail investors’ motives for trading appear to be gambling and entertainment and that they incur substantial losses on their options investments — much larger than their losses on equity trades.
Investor takeaways
Elimination of commissions has fuelled a retail participation boom in financial markets, a rise in day trading and the “gamification” of investing. The success of the zero-commission business model relies on payments for order flow from intermediaries that execute retail orders. That model incentivises brokerages to induce more trading. Given that retail investors are basically uninformed and have a preference for lottery-like investing, wholesalers (like the casinos in Las Vegas) are extracting billions in spreads (since bid-ask spreads on options exchanges are considerably higher than those on stock exchanges, market makers that receive retail buy and sell orders are likely to benefit more from executing transactions in options, often crossing these trades) from the pockets of naive individuals who are engaging in something that is more akin to gambling than investing. Adding to the losses caused by expensive trading is that naive retail investors fail to optimally exercise options.
The evidence makes clear that while the new generation of retail investors are tech-savvy, they are uniformed amateurs who act more like gamblers in casinos than investors in capital markets. The result is that their options trading is highly unprofitable to them, but highly profitable for the wholesalers making markets in the options and paying for the order flow. Forewarned is forearmed.
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