The Wealth-Destroying Behavior of Retail Option Trading
If your clients are seduced by television advertisements offering untold wealth accumulation through options trading, new research shows just how destructive that type of speculation has been.
The COVID pandemic coincided with a dramatic rise in retail investor participation in options markets. In 2020 alone, retail investors accounted for more than $250 billion of total single-name option volume. Is the attraction financially rewarding, or are option buyers, in effect, buying lottery tickets?
Tim de Silva, Kevin Smith and Eric So, authors of the December 2022 study, “Losing is Optional: Retail Option Trading and Earnings Announcement Volatility,” examined: the drivers of retail investor participation in options markets; how retail demand influenced the cross-section of option prices; and how their behavior differed across equity option markets. They used a dataset from the Nasdaq stock market that detailed buying and selling volumes at the contract-day level for options traded on Nasdaq and OMX PHLX exchanges. The data accounted for approximately 25% of market-wide option volume over their January 2010-February 2021 sample window. A key feature of the Nasdaq data is that it allowed them to observe whether a trade originated from retail, professional customers, market makers, firms or broker/dealers. Following is a summary of their key findings:
- The extent of retail trading in options has grown substantially over time, increasing more than 10 times over the past decade in terms of dollar volume traded – from approximately $20 billion in 2010 to approximately $240 billion in 2020.
- For all client groups, option trading activity concentrated around firms’ quarterly earnings announcements, particularly those with greater expected abnormal volatility, relative to non-announcement periods – concentrating in firms with preannouncement media coverage – suggesting attention effects strongly contribute to preannouncement retail options demand.
- Retail investors and market makers were the most active client groups around earnings announcements, with market makers largely offsetting positions by retail investors.
- Since most retail option demand ahead of high earnings announcement volatility (EAV) announcements is absorbed by a single client group (market makers), demand-based option pricing theory predicts market makers are likely to charge exceptionally high premiums to accommodate that retail demand. The result is that retail investors’ option demand generates a large price impact prior to high EAV earnings announcements – for announcements in the top quintile of retail options purchases, option-implied variances escalated by roughly 40% more in the days immediately prior to the announcement dates compared to announcements with no such purchases.
- Retail investors displayed a trio of wealth-depleting behaviors: They overpaid for options relative to realized volatility, incurred enormous bid-ask spreads (the typical percentage half-spreads that retail traders incurred were about 8%) and sluggishly responded to announcements even as their prices predictably decayed. These behaviors resulted in losses of 5-9% on average, and 10-14% for high-expected-volatility announcements.
- The delay in closing losing positions was likely driven in part by a disposition effect – the investor tendency to sell winner assets too early and to hold loser assets too long.
- Retail investors lost approximately $3 billion on option investments during the sample window, with market makers being the primary beneficiaries (they earned the wide bid-offer spreads).
An interesting finding was that retail investors lost an average of 250 basis points (bps) per day on their long positions (buying calls) for the 10 days following the announcement, and they lost around 55-70 bps more on high EAV announcements; but they made on average 180 bps on their short positions (buying puts) over the same time period, and gained around 35 bps more on their short positions around high EAV announcements. The finding that retail short sellers generate profits is consistent with those of the authors of the 2020 study, “Smart Retail Traders, Short Sellers, and Stock Returns,” who found that retail short sellers, like institutional short sellers, are informed traders who profitably exploited public information when it is negative.
De Silva, Smith and So noted that their finding that retail investors paid enormous spreads was consistent with those of the authors of the October 2022 study, “Retail Trading in Options and the Rise of the Big Three Wholesalers,” who found that option market makers earned substantial profits by trading against retail order flow. They also noted that their findings of poor performance by retail option trades is consistent with those of the authors of the study, “Option Trading and Individual Investor Performance.” They found that “the average option investor loses 1.81% per month in gross terms during the sample period, which is economically large and statistically significant at a 1% level” and concluded that “most investors incur substantial losses on their option investments, which are much larger than the losses from equity trading.”
Their findings led de Silva, Smith and So to conclude “that retail investors are drawn to options by anticipated spikes in volatility around these announcements, and that this appears to be linked to retail attention spurred by media coverage.” They added: “Our results indicate that retail traders demand liquidity and seemingly lack private information when trading in options around earnings announcements, suffering large losses as a result.” They also noted: “These findings, which became even more prominent during the COVID pandemic, complement the evidence in Barber, Huang, Odean, and Schwarz (2021) that recent generations of retail investors behave differently than those documented in studies from the 1990s.”
Trading in equity options is attractive to individual investors because of their considerable embedded leverage and the opportunity it presents for lottery-like wins. The attraction exists even though there is now a large body of research demonstrating that options trading, particularly the buying of calls, has transferred of billions of dollars from the wallets of retail investors to the pockets of the market makers in those options. That explains all those commercials from broker-dealers touting their options-trading offerings!
One of the most important roles of a good investment advisor is preventing clients from engaging in wealth-destructive behaviors. Providing clients with the evidence increases the odds that they can be convinced against engaging in such activities.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.
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