Retail traders using sophisticated quantitative strategies are starting to have a surprising and noticeable impact on financial prices. Many commentators criticize such do-it-yourself investing as the road to disaster for investors and a destabilizing force for markets. In fact, in a world where passive investing is exploding, this is a reassuring counter current that should aid in price discovery and bring some balance to the makeup of the market.
Speaking at the Options Industry Conference recently, Henry Schwartz, vice president of market intelligence at Cboe Global Markets, showed a slide with large volume spikes in zero-day-to-expiration options for the S&P 500 Index caused by small (under 10 contracts) orders. These ultra short-term contracts are popular with retail quantitative traders and now represent the majority of S&P 500 options volume, often exceeding half the total trading in the S&P 500 itself. If there is enough retail quant trading to drive large spikes in volume, these trades may well be affecting the price behavior of the S&P 500. Moreover, if it’s happening with the S&P500, it could be happening with other major markets, too.
It’s easy to come up with reasons for the growth in retail quants. Most quants exploit small edges, which require very low transaction costs. A few years ago, big institutional investors could trade much more cheaply than the retail crowd. Today, it’s easy to find zero-commission retail brokers — some with rebates that actually pay customers to trade — and the small size of retail quant trades means there’s less market impact from any individual trade. A retail quant buying or selling a few hundred dollars of an option won’t move the price significantly, but a hedge fund trading tens of thousands of dollars will. There are free or cheap tools available to construct strategies without the need for financial research or programming skills, as well as to manage trading with the kinds of algorithms used by professionals. Artificial intelligence tools have accelerated these trends dramatically.
Although retail quants generally lack the quantity and quality of data used by hedge funds, and the diversity of professional expertise, they have the advantage of lower costs, less regulation and no need to please clients. Moreover, while hedge funds typically use a lot of leverage to boost returns, retail quants can run with little or no leverage, meaning lower costs and lower risk.
Zero-day options are short-term bets without significant investment aspects. That is, they are not a way to earn a return on capital, they’re a way to generate short-term profits and losses, without much capital. But many popular retail quant strategies are ways to manage long-term investments. For example, popular value strategies use algorithms to monitor stocks for metrics such as price/earning ratios, profitability and price/book ratios, replacing stocks whose value metrics fall with new names that seem to be more undervalued. Versions of this strategy can produce returns similar to value mutual funds, without the fees. Moreover, they can be tailored to the investor’s tax situation.
An important point is that amateurs do not have to beat professionals to make retail quant attractive. Retail investors do not trade directly against professionals, sometimes retail and professional quants trade together against non-quants. Moreover, retail investors can have advantages in small-capacity trades or if the trader has specialized expertise.
