Why Retail Traders Lose in the Options Market

The options market has traditionally been considered the domain of sophisticated institutional investors, but recent years have seen a dramatic shift.

Facilitated by the advent of zero-commission trading on apps like Robinhood, retail investor activity in U.S. options has soared, reaching over 60% of the total market volume.

The new generation of retail investors is often young and tech-savvy, but many are financial novices, with a significant number opening a brokerage account for the first time in 2020.

Despite the excitement generated by this boom, research reveals that the aggregate outcome for these retail participants is poor: they lose money on average. From November 2019 to June 2021, the aggregate portfolio of retail investors suffered losses estimated at $2.1 billion (assuming a 10-day holding horizon).

These losses are driven by a convergence of factors related to the assets retail investors choose, the hidden costs they incur, and the structure of the market itself.

This article is based on the research paper called Retail Trading in Options and the Rise of the Big Three Wholesalers by S. Bryzgalova, A. Pavlova, T. Sikorskaya.

Related reading: –33 Best Option Trading Strategies

The Hidden Costs of “Zero-Commission” Options Trading

While many platforms advertise commission-free options trading, the majority of retail losses stem not from direct fees, but from hidden, implicit costs.

• Implicit Costs Dominate: The bulk of retail losses comes from indirect costs of trading. These costs, measured as the difference between the trade price and the mid-quote, amounted to a staggering $6.4 billion during the study period. This number is nearly seven times higher than the estimated direct trading costs (commissions) of about $900 million.
• Costs are Obfuscated: The zero-commission model likely obfuscates the high true trading costs associated with options. Because these costs are not transparent, retail investors may overlook them.
• Massive Bid-Ask Spreads: Retail investors overwhelmingly prefer ultra short-term options (those with less than a week to expiration). These contracts are expensive to trade: the average quoted bid-ask spread for these weekly options is a whopping 12.6%. This cost is orders of magnitude higher than trading costs observed in equities.

The Price of Speculation: Why Retail Traders Choose High-Risk, Short-Term Options

Retail traders exhibit clear preferences, suggesting their motivations are more speculative or gambling-related rather than driven by traditional hedging motives.

• Ultra Short-Term Preference: Nearly 50% of retail trades are in ultra short-term options (less than a week to expiration). This preference might be driven by the psychological appeal of assets resembling lotteries or gambling.
• High Leverage, Low Price: Weekly options provide high embedded leverage, sometimes exceeding 50. Additionally, these contracts have the lowest prices compared to identical contracts with longer maturities, attracting retail investors who may be cash-constrained and seeking the cheapest alternative, despite the high spread costs.
• Call Dominance: Retail investors strongly favor buying call options (bets on rising stock prices) over put options, with calls representing about 69.4% of their volume share. They also tend to trade contracts that are at-the-money (72% of trades) or slightly-out-of-the-money (23% of trades), with the latter involving especially high trading costs (average quoted spread of 28.7%).
• Lack of Learning: Retail investor underperformance seems persistent; they lost more money during the later periods of the sample, particularly around the GameStop frenzy in early 2021. This suggests that they may not be learning from their trading experience.

Payment for Order Flow (PFOF): How Market Structure Works Against Retail Investors

The modern zero-commission options market is built on the controversial practice of PFOF, where brokerages profit by routing customer orders to wholesalers for execution. This system is highly profitable for wholesalers and creates potential conflicts of interest.

• PFOF Concentration: The options market generates significantly more PFOF revenue for brokerages than the stock market. In 2021, U.S. brokerages received $2.4 billion in PFOF for options, compared to $1.3 billion for equities. The options wholesale market is highly concentrated, with the top three wholesalers (Citadel, Susquehanna, and Wolverine) accounting for nearly 90% of the PFOF as of Q2 2021.
• Effective Internalization: Though all options must trade on exchanges, the retail orders are often executed through special processes called price improvement mechanisms (SLIM), which effectively amount to internalization by the wholesalers. Exchange fees are structured to be prohibitively expensive for other market makers (“responders”) trying to compete for these orders, ensuring the original wholesaler retains the trade.
• Conflict of Interest: The reliance on PFOF means brokerages are incentivized to route orders to whichever venue provides the best rebate (PFOF). This can create a conflict of interest, potentially leading brokerages to encourage more trading, especially in less liquid assets like options, which generate higher wholesaler profits.
• Default Settings: Regulators should investigate whether investor choices are truly based on preference or whether short-term, high-risk options are presented as the default choice on trading apps, which could incentivize too much churning.

Key Takeaways – Why Retail Traders Lose In The Options Market

The losses incurred by retail options traders are primarily concentrated in long positions of short-term (weekly) contracts. Conversely, those who sell these short-term options tend to make significant profits.

The findings underscore the need for greater transparency in options trading costs, particularly since the indirect costs are “orders of magnitude higher” than those associated with stock trading.

Furthermore, policymakers must address the conflicts of interest inherent in the PFOF model and potentially regulate default settings on trading platforms to protect novice investors.