Market newbies got an investing lesson during the pandemic. The cost: losses of $1.1 billion in options trading

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The rise of options trading among average Americans during, and since, the pandemic has been hailed as a welcome introduction to markets for newbies.

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It’s not. It has been an unmitigated disaster to the benefit of three firms and billions of dollars.

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Small options trades grew by 224% from late 2019 through mid-2021. That was during a time when stocks plunged, then soared, and the media relentlessly covered meme stocks and outsized gains for “beach bums” like Mike McCaskill.

Anecdotes are not data, and the data are stunning.

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Coinciding with the mailing of stimulus payments in mid-2020, the smallest of options trades exploded relative to total volume. From 2002 to 2019, small traders made up about 15% to 20% of all option volume. From mid-2020 through today, that share has doubled.

During the bulk of this period, retail options traders lost $1.1 billion on their trades. That’s where part of the $817 billion in stimulus checks went — up in smoke in short-term call options.

Call it what it is: Gambling

During the explosion in trading volume, small traders were buying at-the-money or slightly out-of-the-money call options. Only about 4% of volume was focused on deep in-the-money options, which can carry tighter spreads on liquid stocks.

Since stocks rose following the pandemic panic, traders spent 69% of their volume on calls. Most remarkably, about 50% of all trades expired in less than a week. Stocks had to rally immediately and significantly to overcome the effects of trading costs, commissions and time decay. It was pure gambling and was especially heavy in meme stocks including GameStop GME,
-12.27%
and AMC AMC,
-6.65%,

Hidden role of ignorance

When you buy an option to open, you have to pay the asking price, unless you place a limit order (which retail investors tend not to do) or get lucky by having a broker who gets you a better price. From November 2019 through June 2021, retail traders lost more than $4.1 billion to trading costs that include bid-ask spreads like these.

Across those trades, the bid-ask spread was as high as 12%. That’s an immediate loss if an investor tries to turn around and sell the option at the bid price.

It was even worse for out-of-the-money options, which was about 24% of volume. Those spreads averaged a whopping 28%. About 14% of trades were “micro” sized, for $250 or less, so up to an instant $59 loss.

The gamification of options trading means that some of the built-in losses were hidden, or at least not properly disclosed. Most of the platforms highlighted their free commissions, without noting that traders faced immediate and substantial losses on every trade.

While some brokerages offer commission-free trading, others do not. During that November 2019 through June 2021 period, retail traders lost another $800 million in commissions alone.

Gifts for Wall Street

Being new to the options market, many traders who bought in-the-money call options didn’t exercise them prior to their ex-dividend dates. As such, they weren’t entitled to the dividend payouts.

Maybe it was just laziness, but we’ll give them the benefit of the doubt. This is a fairly esoteric process, and who wants to think about boring dividends when GME is skyrocketing?

When call option holders don’t optimally exercise their dividends, then the option writers can receive windfall gains. Which some did.

On the other side of these trades were three firms to the exclusion of almost all others: Citadel Securities, Susquehanna and Wolverine. The firms accounted for 85% of payment for order flow in the options market, thanks in large part to large trade flows coming from Robinhood HOOD,
-4.35%,

What can be done?

There is no single solution that can be handed down from regulators to fix all the issues. The biggest reasons for the losses were due to fundamental human errors — greed and ignorance.

Still, brokerage firms that offer options trading to retail investors could more clearly express the cost of trading options, including bid-ask spreads.

If a trader enters a buy order for an option expiring within a week or two, firms could create or enhance risk disclosures highlighting the large probability of loss.

For traders who currently hold in-the-money call options, brokerage firms should send alerts that prompt the option holder to exercise their options prior to ex-dividend dates.

(Note: Most of the data for this article are from an eye-opening paper by Bryzgalova, Pavlova, and Sikorskaya published in April 2022.)

Jason Goepfert is the founder and chief research officer of Sundial Capital Researcha Minneapolis-based research firm.

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Credit: www.marketwatch.com /

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