While options can be used for good, some of their features, like embedded leverage, make them a double-edged sword.onuma Inthapong/iStockPhoto / Getty Images
Roaring Kitty – or Keith Gill, the guy behind the ongoing GameStop saga – inspired retail investors around the world to build wealth by trading options, but, unfortunately, most retail investors are unlikely to replicate his success.
Options are financial contracts that give the option holder the right, but not the obligation, to buy or sell a set quantity or dollar value of an asset at a fixed price by a set date.
They are useful tools for many reasons and have arguably revolutionized not only finance but the whole economy. While they can be used for good, some of their features, like embedded leverage, make them a double-edged sword.
They can just as easily be used for risk management and hedging as they can for speculation and gambling. Retail options trading has exploded in popularity over the past few years.
It’s hard to look at Roaring Kitty and not imagine trading your way to extreme wealth by taking similar risks. Experimental research suggests that this is roughly what happens to people when they observe successful traders: They increase their own risk-taking.
It doesn’t help that retail-focused trading platforms are eager to promote their options trading capabilities to customers. Make no mistake, options trading is lucrative for the retail brokers promoting it.
The reality is that trading options has not been great for retail investors. A study involving 68,000 accounts and more than eight million trades in stocks and options at a large online broker in the Netherlands found that most investors took significant losses on their options investments – much larger than the losses investors take on equity trading.
The research suggests that gambling and sensation-seeking – rather than hedging – are important determinants of retail option trading.
Similarly, a 2023 paper in the Journal of Finance found behaviour consistent with speculative retail options trading. The authors showed that retail investors often preferred cheaper, weekly options with an average bid-ask spread of 12.6 per cent – and lost money on average.
Retail investors also seem to be attracted to attention-grabbing options around announcements with high expected announcement volatility, which, according to a 2022 study, resulted in average losses of 10 to 14 per cent.
A 2021 study of the South Korean options market showed that retail investors generally prefer simple options strategies that provide directional exposure to the underlying asset. They also tend to lose on their trades.
The median retail options trader in this sample lost approximately 21 per cent of their annual household disposable income – about US$5,000.
A 2023 study looked at how retail investors tend to use complex options strategies. The authors found that commission-free trading for multileg options strategies coincided with a huge jump in complex trades placed by retail investors.
One of the problems with complex financial instruments is that they are harder to understand, particularly for less sophisticated investors.
Unsurprisingly, the authors found that traders in the sample preferred strategies with high volatility, embedded leverage and lottery-like features, exhibiting an optimism bias.
On average, they earned negative returns, and their losses increased with the complexity of their trades.
These findings suggest that retail investors may not fully understand the risk-return trade-offs in complex options strategies and are lured in by leverage and the potential for lottery-like payoffs.
Despite some incredible success stories, trading options has generally been a disaster for retail investors.
They pay huge transaction costs and engage in largely speculative trading using simple options strategies. When they trade complex options, they do even worse. The result, across multiple studies, is that retail investors typically lose money trading options.
All these negative effects seem to be amplified when investors are shown a successful trader’s outcome, which, in the world of social media, is easy to find.
For most investors, building wealth is not something that happens with one big winning trade in the options market. It’s a long and boring process that consists of saving and investing in a diversified, low-cost portfolio. Chasing big wins by trading options is more likely to destroy wealth than create it.
Benjamin Felix is the chief investment officer and a portfolio manager at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.
