While options can be used for good purposes, some of their characteristics, such as embedded leverage, make them a double-edged sword.onuma Inthapong/iStockPhoto / Getty Images
Roaring Kitty – or Keith Gill, the man behind the ongoing GameStop saga – has inspired retail investors around the world to build fortunes through options trading, but unfortunately, most retail investors are unlikely to be able to replicate his success.
Options are financial contracts that give the option holder the right, but not the obligation, to buy or sell a specified quantity or dollar value of an asset at a fixed price until a specified date.
They are useful tools for many reasons and have arguably revolutionized not only the financial world but the economy as a whole. While they can be used for good purposes, some of their characteristics, such as embedded leverage, make them a double-edged sword.
They can be used for risk management and hedging as well as speculation and gambling. Retail options trading has exploded in popularity in recent years.
It’s hard to watch Roaring Kitty and not imagine becoming extremely rich by taking similar risks. Experimental research suggests that this is roughly what happens to people when they watch successful traders: They increase their own risk appetite.
It doesn’t help that retail-focused trading platforms eagerly promote their options trading features to clients. Make no mistake, options trading is lucrative for the retail brokers who offer it.
In fact, options trading is not particularly advantageous for retail investors. A study of 68,000 accounts and more than eight million stock and options trades at a large Dutch online broker found that most investors suffered significant losses on their options investments – much larger than the losses investors suffer when trading stocks.
Research suggests that gambling and sensation seeking – rather than hedging – are important determinants of retail options trading.
A 2023 Journal of Finance article found similar behavior 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 percent – 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 losses of 10 to 14 percent on average.
A 2021 study of the South Korean options market showed that retail investors generally prefer simple options strategies that provide targeted exposure to the underlying asset. They also tend to make losses on their trades.
The average retail options trader in this sample lost approximately 21 percent of his or her annual disposable household income—about $5,000.
A 2023 study examined how retail investors tend to use complex options strategies. The authors found that commission-free trading in multi-leg options strategies was accompanied by a huge increase in complex trades by retail investors.
One of the problems with complex financial instruments is that they are more difficult to understand, especially for less sophisticated investors.
Not surprisingly, the authors found that traders in the sample preferred strategies with high volatility, embedded leverage, and lottery-like features, thus exhibiting an optimism bias.
On average, they generated negative returns and their losses increased with the complexity of their transactions.
These findings suggest that retail investors may not fully understand the risk-reward trade-offs in complex options strategies and may be attracted by leverage and the possibility of lottery-like gains.
Despite some incredible success stories, options trading has generally been a disaster for retail investors.
They pay enormous transaction costs and engage in largely speculative trading with simple options strategies. They perform even worse when trading complex options. The result of several studies is that retail investors generally lose money when trading options.
All of these negative effects seem to be amplified when investors are shown the results of successful traders, which is easy to find in the world of social media.
For most investors, building wealth is not something that happens with a single big winning trade in the options market. It is a long and tedious process that consists of saving and investing in a diversified, low-cost portfolio. Chasing big profits through options trading is more likely to destroy wealth than it creates it.
Benjamin Felix is portfolio manager and head of research at PWL Capital. He is co-moderator of the Rational memory podcast and has a YouTube Channel. He is a CFP® expert and CFA® charterholder.
