In 2018, the Robinhood fintech app made a change that lowered the barrier to investing in the stock market – reducing the commission and contract fee for buying and selling complex (multi-leg) options to zero.
Other platforms also implemented this change that empowered retail investors interested in trading complex options, which accounted for nearly 20% of the retail options trades in July 2022, a significant portion of an already popular investment area. According to the Options Clearing Corporation, on average, 39 million options contracts were traded daily in 2021, and the dollar trading volume in options grew by 143% from November 2019 through July 2021.
Since the introduction of zero commissions for complex options, there has been a significant rise in option retail trading activity. After the introduction of zero commissions for complex options, complex options trades (volumes) favored by retail investors increased by more than 75.4% (43.5%) compared to options on other stocks, according to University of Florida researchers using retail trade-level data of multi-leg complex options from a major options exchange.
Despite the lower entry barrier and subsequent growth in options trading, trading complex options isn’t a winning strategy for most retail investors, according to new research from the University of Florida.
“Retail investing in options has grown over the past few years thanks to the easiness of fintech apps, eliminations of trading commissions and increased social media attention,” said Yanbin Wu, Clinical Assistant Professor and research co-author. “But less sophisticated and overly confident retail investors tend to lose money on trading complex options with shrouded risks.”
John H. and Mary Lou Dasburg Chair Mahendrarajah Nimalendran, Susan Cameron Professor Andy Naranjo and Clinical Assistant Professor Yanbin Wu.
Wu and University of Florida co-authors Andy Naranjo and Mahendrarajah Nimalendran find that retail traders lose money over one-, two- and three-day periods, averaging a loss of 16.4% over three-day periods. Additionally, the researchers find that complex option trading is elevated around earnings announcements, and retail trader losses are three times larger on these trades.
Part of the reason for losses on complex options is related to retail traders’ preferred strategy, the researchers noted.
“We find that retail investors favor highly volatile, large-cap stocks and stocks that are liquid with a high turnover,” Wu shared. “The consistent average negative returns on their complex trading bets suggest that retail investors are, on average, uninformed and are attracted to low priced, high leverage strategies.”
For those retail investors determined to have success trading complex options, the researchers recommend exercising caution.
“Retail investors need to be cautious about the embedded leverages and shrouded risks associated with different multi-leg strategies, similar to those associated with structured bank products,” Wu said.
Wu also warned of the retail trading platform designs that encourage trading on complex products.
“The oversimplified platform encourages extensive trading on complex options while the investors are not fully aware of potential risks,” he said. “More complex strategies do not necessarily deliver higher expected returns/Sharpe ratio.”
