Since the launch of Robinhood in 2015 with its “zero, nada, zilch” commission-free trading, professional investors have got used to the fast-growing presence in their markets of amateurs and their gambling, thrill-seeking, Reddit-message-board-fuelled behaviour—and what they can do to prices.

The brokerage’s active users grew to 22.5 million by the end of 2021. And though the sway of retail traders in single-name options markets has faded from its peak during the meme-stock frenzies of early 2021, they remain a force that other market participants have to reckon with.

Understanding when, why and how these investors trade remains a work in progress. Much of the examination of what they do occurs behind closed doors at hedge funds and market-makers that are secretive about their findings. “We know very little about retail trading outside of the equity market,” says Tim de Silva, a researcher at the Massachusetts Institute of Technology. “There’s a massive literature that examines how retail investors behave trading stocks, but there has been much less done on how retail investors participate in these other markets. This is a relatively new phenomenon.”

Yet recent studies using freshly unearthed datasets are attempting to fill in the gaps.

The subject is of interest to professional investors and market-makers not least because retail traders tend to lose money, which makes their behavior a source of returns for others.

Back in 2021 the Reddit crowd was able to wipe out hedge funds such as Melvin Capital. Yet as a group, and over time, they have given up meaningful sums. By different estimates, they surrendered $5 billion in transaction costs and perhaps more than $1 billion in losses during the pandemic.

One buy-sider describes their advance into options as the “ultimate bonanza” for the wholesalers on the other sides of the trades.

Retail investors also have the heft to push prices around—and not only during the most high-profile events, such as the GameStop episode. Their trading in single-name Nasdaq options grew from about $20 billion in 2010 to around $240 billion by 2020. Retail investors account for nearly half of investor activity by number of trades, according to some estimates.

The Robinhood crowd move volatility surfaces up and down by up to five percentage points, according to one study. This alters the steepness of the slope (which reflects the price of short- versus long-dated contracts) and the curvature of the volatility smile (which captures the difference between options that are in- and out-of-the-money).

The arrival of amateur options traders has caused a “massive shift in the supply and demand equilibrium for single stock volatility”, says Alexis Maubourguet, a portfolio manager trading volatility strategies at Lombard Odier Investment Managers.

The findings of the new research broadly tally with previous studies of retail trading in cash stocks. The amateurs favor lottery-type bets on attention-grabbing names—such as those that are in the news and those whose near-term prospects are most uncertain.

The studies show that retail investors trade heavily in the days leading up to earnings announcements and lose heavily by doing so. The amateurs also seem to be on the wrong end of dividend-related trades, which costs them millions.

Because of how options markets work, the effects are magnified many times over compared with similar patterns occurring in stocks.

At times, the effects are plain to see, academics say. The prices of options on retail favorites, such as electric carmaker Tesla, frequently move higher when the underlying stock is falling. This violates the logic of option pricing, which says prices should be anchored in the volatility of the underlying asset.

“When that happens, clearly something is going on with the option order flow,” says Brian Roseman, assistant professor at Oklahoma State University and author of one recent study. “It’s almost a daily occurrence.” He thinks the likely cause is retail traders making contrarian moves and choosing options as the instruments with which to do so.

Attention to retail

Much of the research uses more granular data that has not been analyzed previously—and some of it uses novel ways to tease out what is and is not retail activity.

A team from the London Business School examined data from the Options Price Reporting Authority. In November 2019, Opra began to flag trades that options wholesalers, such as Citadel Securities and Susquehanna International Group, subject to so-called price improvement mechanisms—a reliable proxy for retail activity because such mechanisms are how zero-commission trades are executed.

“We didn’t have the data before,” says Anna Pavlova, professor of finance at London Business School and academic director of the AQR Asset Management Institute. She estimates that the new flags enable researchers to capture about 30% to 40% of all retail trades by volume.

The result, Pavlova explains, is to provide a “unique laboratory” in which researchers can study flows they could not observe before, including trades that capitalize on patterns in retail activity: “Now we can see exactly what these arbitrage trades are.”

In another study, de Silva worked with associate professors Eric So of MIT and Kevin Smith of Stanford University to track retail trading around the time of earnings announcements. The researchers used daily data from Nasdaq’s Options Trade Outline and PHLX Options Trade Outline databases. The data, which academics had not studied before this year, categorizes traders depending on their patterns of activity and includes segments for retail traders, market-makers and professional investors.

In yet another study, researchers from Oklahoma State, Emory University and the University of Florida used brokerage platform outages—times when retail investors were unable to trade—to isolate and analyze the traders’ influence on options-implied volatility. The research looked at 80 platform outages at large retail brokers such as Charles Schwab, E-Trade, Robinhood and TD Ameritrade from January 2019 to July 2021.

Read all about it

The findings of all these studies show retail traders reacting en masse to news headlines while on the hunt for lotto-style bets: trades with a small chance of a big win.

“They absolutely love ultra-short-term options,” Pavlova says. “That’s very different from the rest of the market.”

The team from London Business School found that retail options traders prefer cheaper options and weekly options, even though such options are more costly to trade than others.

Retail investors on average transacted at a bid/ask spread of 13.7% during the period of the study—15% higher than average spreads for the market as a whole. They also tended to be bullish: 69% of the volume of options in the study were calls—directional bets on stocks rising rather than falling.

The study of the effects of outages reached similar conclusions. Here, too, traders could be seen to favor call options, short-dated options and out-of-the money options. “These are more speculative plays, with lottery-like payouts,” says Greg Eaton, assistant professor at Oklahoma State, who worked with Roseman on the research.

The MIT and Stanford researchers observed that retail trading around earnings announcements caused volumes to spike to two or three times normal levels, while trading from professional investors remained subdued. Here again, the retail crowd appear to have been behaving like headline-fixated thrill seekers.

“We tried to simply document the basic facts about how retail investors trade options,” says de Silva. “Regardless of what measure we use, we find retail investors are a lot more likely to buy options around announcements when there’s a lot of news or when there is a lot of action expected.”

The greater the perceived risk—visible in the price of options that mature before and after the announcements—the more heavily retail investors traded a stock’s options.

Retail traders’ behavior has the potential to buffet prices violently. The researchers from MIT and Stanford found that the effect of retail flows could be up to 15 times greater than similar flows around earnings announcements in stocks.

De Silva explains that market-makers quote wider bid/ask spreads when heavy retail buying exposes them to the risk of price jumps in the underlying—such jumps are costly to hedge against. Typical bid/ask spreads would be about a fifth of the option price around announcements, and even wider for options traded around high-volatility announcements.

Market participants agree. “Ahead of a volatile earning event the market is typically going to be a bit thinner and wider,” says Chris Murphy, co-head of derivatives strategy at Susquehanna, one of the biggest wholesalers in single-name options. He adds that earnings announcements are the most volatile event investors must hedge against, so it’s no surprise they pay heavily: “The reality is: that’s what insurance is.”

When Roseman and his fellow researchers examined the effect of outages—when retail investors were absent—they found that implied volatility dropped overall and especially for the options that retail investors tended to trade most heavily.

“Retail traders in the options markets tend to push up implied volatility through demand pressure for non-fundamental, non-information reasons,” says Eaton. In simple terms, they move options prices and not because they know more than other investors.

During outages, average implied volatility for stocks favored by retail investors fell by 5.3 percentage points for out-of-the-money options relative to a median volatility of 51%. In-the-money options fell by 4.4 percentage points.

However, in a working paper the academics stated that the strongest effect could be seen in the slope of implied volatility surfaces: “By pushing up short-dated volatility and decreasing long-maturity volatility, [retail] trading adds considerable negative slope to the volatility term structure.”

Such effects have the power to upend investing strategies, but equally to help in the formulation of new ones.

Retail traders are losers

In aggregate, retail traders lose money from the trades they make over one-, two-, five- and 10-day horizons, according to the London Business School researchers. If investors held positions for 10 days on average, that would equate to losing $1.2 billion between November 2019 and June 2021.

In trading costs, measured as the difference in the trade price from the midquote, retail traders gave up $5.2 billion over the same period.

Option trading is a zero-sum game. Those costs and losses therefore equate to revenue for wholesalers and exchanges executing retail trades, and hedge funds trading in the opposite direction.

Retail investors lose out in specific ways, too. They largely fail to exercise call options when impending dividend payments mean they should.

Pavlova says this failure to exercise options could be the result of oversight or a lack of expertise. Calculating option values requires complex pricing models that retail traders may not typically use.

Exercised options are assigned randomly to option writers by the clearing house. This means the assigned writers must deliver the underlying and dividend to the contract holder. With some options unexercised, some writers stay unassigned and so pick up the dividend for themselves.

Arbitrageurs exploit such mistakes through so-called “dividend plays”—trades from which they earned $96 million during the period of the study, Pavlova and her colleagues estimate.

An arbitrageur can secure a windfall by buying and exercising a large volume of options along with matching short positions. By doing so, it harvests the dividend on the shorts that remain unassigned. The greater the size of positions the arbitrageur holds, the higher the likely return.

The trade leaves a clear signature in the data Pavlova and her colleagues have analyzed. “We saw these enormous spikes in trading volume,” she says. “It just jumped out at us.”

The MIT and Stanford researchers found that retail investors collectively lose about 10% on their options bets in the 10 days following anticipated high-volatility announcements, even before allowing for transaction costs.

By extension, a standard hedge among market-makers looks highly profitable. Selling volatility around high-volatility announcements and buying around lower-volatility announcements would earn 11% on average on a given announcement date, the academics found, and a further 9% over the following two weeks.

De Silva and his colleagues estimate that hedge funds are harvesting about a fifth of the gains from options trading around earnings announcements. Maubourguet says the retail trade has been a source of alpha for Lombard Odier: “Our job is to monetize dislocations.”

However, he adds that hedge funds are picking up “breadcrumbs” compared with market-makers when it comes to this specific business. The bulk of retail positions are opened and closed within a few hours, which gives market-makers an advantage because they directly face the retail end-clients. They have no latency, he explains, and can capture the easiest part of the margin.

Referring to trading around earnings announcements specifically, Susquehanna’s Murphy says: “Market-makers aren’t necessarily trying to take huge positions against the other side of these events, even though in the long run it does seem they win.”

Singles out

Retail trading of single-name options has waned this year, falling to about a third of levels at the height of the meme stock mania in February 2021.

That said, volumes remain 50% higher than before the pandemic and have spiked periodically. Maubourguet says the effect of retail trading on the absolute level of implied volatility has fallen away for now.

However, retail activity could re-escalate. “In a stagnant market or a slowly dropping market—there are a bunch of reasons why retail investors trade less,” says Terry Odean, a professor at the University of California, Berkeley who has been studying retail investors’ behavior since the early 1990s.

The phenomenon of investors sharing information and co-ordinating action through forums such as Reddit is unlikely to stop. “Overall volume is likely to drop whenever the market settles down and becomes a more boring place,” Odean says. “But there has been a permanent change in what information is available and how it is communicated.”

Even in a bear market, amateur investors have the capacity to herd, as was made clear by the recent trading in new retail stock favorite Bed, Bath & Beyond. The rolling seven-day average turnover in small out-of-the-money options in the homeware retailer jumped to $42 million a day in recent weeks, according to data from VandaTrack. That represents about 14% of total turnover.

Retail investors may also be changing how they act. Data from OptionMetrics shows that the share of index option trading from retail investors rose from 20% to 30% of all volume between January and August. The data provider uses single-lot sized trades as a proxy for retail activity.

OptionMetrics’ head of quantitative research Garrett DeSimone says most of the activity is buying out-of-the-money index puts, which suggests retail traders are switching from bets on the good fortune of individual companies to broader bets on market-wide falls. He believes the uptick could be the start of a “new paradigm” in which a heightened presence of retail traders in index options would lead to elevated implied volatility in these types of instruments as well as in single-name options.

Other market participants will be watching closely. Maubourguet says Lombard Odier runs models constructed to identify any unusual patterns in options prices: “We have our game plan, and we are ready to react fast.”

Correction, September 22, 2022: An earlier version of this article referred to hedge fund Citadel rather than Citadel Securities, which is a separate entity. We have made the correction.