By Tim de Silva, Massachusetts Institute of Technology, Sloan School of Management
Retail investor trading in options took off during the COVID pandemic, and in 2020, retail investors accounted for more than $250 billion of total single-name option volume. With the meme stock frenzy that same year, many pondered the impact these investors may be having across a variety of markets. And, as the markets have taken twists and turns since, others wonder if retail option traders may realize the risks associated with investing in these less traditional investments.
From options to foreign exchange and crypto—there has been a growing participation of retail traders trading in a variety of asset classes outside of stocks. While the broadening of retail investor participation to other asset classes clearly has some benefits, it has also sparked a regulatory debate around whether these other asset classes pose additional risks that might be harmful. Properly weighing these benefits and costs of greater retail participation requires a detailed understanding of retail investors’ trading behavior.
Kevin Smith of the Stanford University Graduate School of Business, Eric C. So of the Sloan School of Management at Massachusetts Institute of Technology, and I recently became interested in this debate. In new research, titled “Losing Is Optional: Retail Option Trading and Earnings Announcement Volatility,” we try to make progress on some basic questions relevant to the debate around retail investor participation, such as what drives retail option trading, how do retail option trades perform, and what effects does retail option trading have on equilibrium prices. Collectively, our findings offer novel evidence on both the determinants and consequences of retail trading in options markets.
Three Motivating Facts
In “Losing is Optional: Retail Option Trading and Earnings Announcement Volatility,” we begin our analysis by documenting three facts, using a combination of option price and volume data from OptionMetrics and data from Nasdaq on the options trading behavior of different clientele groups (e.g., retail, market makers, broker/dealers).
- First, the extent of retail options trading has grown dramatically over time, with retail investors accounting for $250 billion of total single-name equity option volume on the NDX and PHLX options markets.
- Second, single-name equity options trading is heavily concentrated around earnings announcements.
- Finally, most of the option trades around earnings announcements are between market makers and retail investors.
Collectively, these three facts suggest that in order to understand retail options trading, we need to understand how retail traders trade around earnings announcements, given this makes up most of their trading. As a result, we devote the majority of our analysis to exploring the determinants of the heavy trading by retail investors around earnings announcements.
Our Main Result: Expected Volatility is a Key Driver of Retail Option Trading
Our central finding is that retail investors are significantly more likely to buy options ahead of announcements with higher expected abnormal announcement volatility (EAV). To measure expected announcement volatility (EAV), we use a measure based on the implied volatility of options from OptionMetrics, given option prices are dependent on the expected volatility of the underlying stock in the future. The intuition for our measure is that the prices of short-term options expiring immediately after an earnings announcement are more sensitive to the amount of announcement volatility and long-term options expiring after the announcement. As a result, we can back out the expected announcement volatility by comparing the prices of these two options. For example, the difference in price between two Apple (AAPL) options with the same strike – one expiring the day before the earnings announcement and the other the day after – captures the expected volatility at the announcement.
Using this measure of EAV, we document the following results:
- Retail investors tend to buy a lot of options in the 3-4 days leading up to earnings announcements, especially for stocks heavily covered in the media and a lot of news around the earnings announcement. This fits closely with narratives that retail investors are scanning what is going on and gravitate to those companies and announcements that are attention-grabbing.
- Because for every buyer there is a seller, another class of investors must absorb this retail trade. We find market makers are the primary traders sitting on the other side, resulting in them holding short option positions around earnings announcements. Since these large concentrated short positions expose market makers to significant announcement risk, option prices rise substantially before the announcement in order to compensate market makers for this risk.
- There is a large wealth transfer from retail investors towards market makers during and after the earnings announcement, as the price pressure created by retail investors reverses. While we find that retail traders investing in options do tend to lose money on options trades overall, it tends to not be by a large amount. However, when it comes to investing in earnings announcements for attention-grabbing companies (which many are drawn to), they tend to lose a lot more. It is really the attention-grabbing announcements, as the title of our research suggests, where retail investor losses are magnified.
- These losses by retail investors are further compounded by two additional factors. First, retail investors’ trades incur substantial transaction costs, as they primarily trade options prior to announcements with lots of expected volatility. These are the options for which bid-ask spreads are the highest. Secondly, retail investors are reluctant to close their positions following the earnings announcements. Notably, this is not the case in the equities market. While the data shows retail investors also invest in stocks leading up to earnings, they tend to be quicker to sell with stocks after the announcement versus holding on to them. This difference may be behavioral, as options, unlike stocks, have a defined expiration date, and hence retail investors may assume that it may not be worth closing the position with options. However, our data does not allow us to precisely pinpoint this mechanism.
- We find that all of these combined effects translate to retail losses of 5 to 9% around earnings announcements on average, and 10 to 14% for high expected volatility announcements. Particularly in recent years coinciding with the COVID pandemic, market makers are the primary beneficiaries of these patterns, with large capital flows from retail to them. While it may appear that market makers are benefitting from retail traders, the former are simply reacting to a residual demand for options. If there is a buyer, market makers, reacting to demand and supply (and setting price accordingly), will have to sell to them. For market makers to sell, they will demand a return for the service – which, in this case, happens to be the return during and after the earnings announcement day. Of course, other effects could be at play that affect the performance of retail investors, such as some of the issues around payment for order flow, but it’s worth nothing that our findings are not inconsistent with market makers behaving competitively.
Why Do Retail Traders Invest in Options the Way They Do?
The next question is why retail traders tend to invest in options around earnings announcements for companies with high expected announcement volatility (EAV). There are three main classes of theories for this type of trading behavior by retail investors:
A natural explanation for buying options prior to high EAV announcements is that retail investors are trying to hedge their exposure in the underlying stock or to variance risks. We have two pieces of evidence against this explanation. First, most retail investors are long rather than short the underlying stock, implying a natural hedge would be to buy put options. In contrast, our data shows retail investors buy exclusively call options. Secondly, if retail investors were trying to hedge exposure to variance risk, we would expect similar behavior from other traders. However, this is not the case.
- Attention Effects
A second possible explanation is that retail investors are attracted to high EAV announcements because they are more likely to capture their attention. To provide support for this hypothesis, we leverage Factiva’s database to measure the number of news articles coming out (e.g. The Wall Street Journal, Financial Times, or New York Times) for each earnings announcement in the week prior to the announcement. Consistent with attention playing a role, we show that the tendency of retail investors to buy options ahead of high EAV announcements is particularly prominent among those announcements that receive more news coverage.
A final explanation is that retail investors actually like investing in options with high EAV announcements because the payoffs are extremely volatile. The payoff of such options is similar to that of a lottery ticket, which many people find attractive despite their negative expected value. Although this theory is difficult to test directly, we view our evidence as more supportive of attention effects, given that we don’t observe retail investors buying the most “lottery-like” options. In particular, they appear to buy medium term at-the-money options, rather than short-term deep-out-of-the-money options.
In assessing these theories, we believe that the most likely motivator is that retail option traders are drawn toward attention-grabbing news. However, as this theory and the pull toward lottery-like investments are hard to separate, we point to them both as potential motivators. Nevertheless, we view separating between these two explanations as an important avenue for future work, given they have very different implications for regulation. If retail investors’ options trades are driven by an underlying stable preference that they understand, then there is less of an argument from limiting their participation in options markets. In contrast, if their trading is driven by attention effects that they are unaware of and cause them to lose money, the case for regulation is stronger.
We hope this research offers insights for retail traders looking to use options to bet on big stock price movements around earnings announcements. Our findings highlight that it’s important to remember that options are priced based on expected future stock price moves, so believing a big future move is likely to occur is an insufficient reason to buy an option. For example, an investor may think buying options on TSLA in advance of earnings is a good move because TSLA stock tends to move big on earnings. However, that move is likely already priced into options. Instead, investors should consider if they believe that TSLA will move more than the market already thinks it will—not necessarily what will happen, but what will happen in relation to what is happening in the options price. The idea that market prices already reflect some information extends beyond options to any other asset class, like stocks or cryptocurrencies.
When it comes to market makers, we think most would not be surprised by our findings. In fact, we have talked to some that say it confirms a sense they have had about what has been going on.
In terms of regulation, we believe that more research needs to be done. While we show that retail investors overall are losing money trading options around earnings, there is no evidence that they are losing utility or welfare. In fact, retail trading in options markets may look similar to how some behave in casinos. And the same discussions, as those had around casinos, will need to occur in options. Do retail investors know the risks, and are they happy to do it? Or are they not aware of how much they are losing? We anticipate they may not be, especially given high transaction costs. However, we don’t have the evidence to settle this debate at this point.
While our paper has a lot to say about how retail traders trade around earnings, there is still a lot of work to be done to assess other drivers of retail option trading, in particular outside of earnings announcements. We hope our paper helps to confirm and spread some knowledge of retail option trading in a market that continues to become less opaque over the years, thanks to improvements in information technology and a large body of academic and industry research on which our paper builds.
Tim de Silva is a Ph.D Student at MIT’s Sloan School of Management. His research focuses on household finance, asset pricing, behavioral economics, and public finance. He has worked on Morgan Stanley’s derivatives trading and research desks and as a quantitative researcher at Analytic Investors.