How Retail Investors Trade Options

Options trading is often thought of as a professional’s domain. However, with the advent of online trading platforms, retail traders now have access to the same tools and information as professional traders. This has changed the dynamics of the options market, as retail traders can now trade options on a level playing field with professionals.

However, a question remains to be answered: do retail options traders have the same knowledge, experience, and discipline as the professionals? Reference [1] examined this question,

We document rapid increases in (i) retail investor trading in options, and (ii) payment for order flow (PFOF) for options transactions received by the U.S. retail brokerages, coming from so-called wholesalers/internalizers—market makers, who execute the brokerage order flow. Exploiting new reporting requirements and transaction-level data, we isolate wholesaler trades and propose a novel measure of retail investor trading in options. We find that retail traders prefer cheaper, weekly options, the average quoted bid-ask spread for which is a whopping 12.3%. The inflow of retail investors also coincides with an increase in calls left suboptimally unexercised on cum-dividend dates. Market makers (and other arbitrageurs) benefit from these mistakes via the so-called ‘dividend play’ trades, producing (virtually) riskless arbitrage profits.

In short, retail traders lack knowledge about options pricing theory and the risks associated with trading options.

The authors also found that the market makers operate in a non-competitive environment,

They [market makers] forgo about 50% of these profits, leaving money on the table for option writers. This behavior disproportionately benefits the Big Three wholesalers, who execute most of the retail transactions in options and often serve as option writers. Our findings are therefore consistent with the non-competitive behavior of market makers and other arbitrageurs.

The findings are very interesting. It’d be useful to look at how retail traders have changed the volatility term structure and dynamics of the option market.

References

[1] S. Bryzgalova, A. Pavlova, T. Sikorskaya, Retail Trading in Options and the Rise of the Big Three Wholesalers, 2022, Working Paper.

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