(Bloomberg) — Of all the risky things amateur investors did while locked at home in the pandemic, dabbling in stock options was one that veteran investors were convinced would end badly.
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They weren’t wrong.
Turns out, taking leveraged flyers on meme stocks mentioned on Reddit’s WallStreetBets trading forum is harder than it looks. New research from economists at the London Business School found that mom-and-pop day traders managed to lose more than $1 billion during the bull market. The bill climbs to $5 billion when the cost of doing business with market-makers is factored in.
The study, “Retail Trading in Options and the Rise of the Big Three Wholesalers,” shines considerable light on the fate of individual investors who became obsessed with side bets on the stock market in the era of zero-commission trading. Spurred by Reddit posts and urged on by Twitter and TikTok influencers, daily volume in bullish contracts set record after record as stuck-at-home tinkerers flocked to the contracts in an effort to juice up returns.
Researchers Svetlana Bryzgalova, Anna Pavlova and Taisiya Sikorskaya estimated that retail investors lost $1.14 billion trading options from November 2019 to June 2021, assuming a 10-day holding period. Trading costs ate up an additional $4.13 billion. To measure the performance of nonprofessional traders, the authors tracked options orders coded as originating with retail brokerages and sent to high-volume market makers known as wholesalers.
A few factors were at play, said the authors, among them hapless market timing by the retail group. Super-wide bid-ask spreads in their options of choice ate up a large portion of the cohort’s potential gains.
Retail traders were a principal pandemic-era Wall Street story. At home with little to do during the early days of the Covid outbreak, many turned to wagering on the stock market. They placed bets on everything from sturdy tech companies to reopening plays and bankrupt firms. It all reached a peak at the start of 2021, when an army of day-traders bid up the prices of so-called meme stocks like GameStop Corp., whose shares skyrocketed more than 50% in a single session on multiple occasions.
The study is one of the first big unpackings of that sensational chapter in modern market history. A sign that era is receding came Tuesday when Robinhood Markets Inc. said it is dismissing 9% of its full-time staff, after the online brokerage’s “hyper growth” has cooled.
But at the peak of the frenzy in 2021, small-time traders were buying more than 23 million call options a week, according to Options Clearing Council data compiled by Jason Goepfert at Sundial Capital Research. That’s way above any other period going back to 2000. Sundial defines small-time as a trader who buy or sells 10 or fewer contracts at a time.
The derring-do of newcomers was frequently called out by Wall Street. One tactic in particular — buying out-of-the-money calls days or hours before they were likely to expire — was pilloried as a newbie gambler’s mistake. In one celebrated instance, more than 50,000 contracts effectively betting that GameStop would surge sevenfold changed hands on Feb. 25, 2021. The option expired the next day.
Trading costs cited by the researchers may not have been easy to discern by many at-home traders. Platforms like Robinhood revolutionized so-called zero-commission trading — they route trading orders to market-makers like Citadel or Susquehanna, who then pay the brokerages for the orders and, in return, provide cheaper trades for the Robinhood clients.
The no-fee trades lured a lot of new clients onto Robinhood and others. But the average bid-ask spread in options with less than a week to expiration is a “whopping” 12.3%, the LBS researchers found. The average quoted spread of retail trades across all maturities is more than 13%, compared with 11% for the overall market. Therefore, they might have underestimated the indirect trading costs in the options market, the researchers wrote.
“The more they trade, the more they lose because of these bid-ask spreads — every time, they have to pay the round-trip trading costs,” said Pavlova in an interview.
Bryzgalova, an assistant professor at LBS, says among the types of contracts and stocks retail traders prefer, “these are all transactions that have lottery-like features.”
“They like skewness in payoffs, they like companies that recently have been traded a lot so they’re quite popular. They like, obviously, cheap contracts because many of them are cash constrained,” she said of patterns she observed among the retail crowd.
Retail traders tend to favor short-term options in particular, she added. “If you buy a call option, you pay some money for it today — and then it either doesn’t work out, so you get zero, or there’s a small chance that you get something positive,” she said. “That’s why it looks like buying a lottery ticket to us,” she said, adding that there are other strategies investors can use that have different profiles in terms of gains or losses.
To be sure, the researchers say they had to work in certain premises since they did not have access to account-level data from a brokerage like Robinhood, meaning a rundown of when a trader moved into and out of certain positions. Therefore, they had to make assumptions about the holding period, as well as prices.
They found that stocks mentioned on WallStreetBets tended to be highly favored by retail investors. That, however, didn’t mean their bets paid off — the list of top losers for retail trades include GameStop and AMC, though both of those stocks are in the top-five-winners basket for the market as a whole.
“So it is about market timing,” said Pavlova. “They were buying these names, but at the wrong time,” and are sometimes choosing the wrong contracts.
Perhaps most striking is that the market during this period racked up impressive gains, even accounting for a 35% Covid-induced decline during the first quarter of 2020. The S&P 500 rose more than 40% between November 2019 and mid-2021. And just about everything caught a bid during that stretch — three of the index’s sectors each added more than 50%.
“Buying options is an easy way to lose money because of the highly-skewed payoff,” Pavlova said. “The options that they like, they lose money most of the time, and sometimes they get these really big wins — but those are rare.”
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