How Amateurs Lost Billions on Options

on social media, that wasn't exactly the whole story. It turns out that collectively, day traders took a massive beating on options trades between November two thousand and nineteen and June of that's according to some researchers from the London Business School who did an in depth study of that wild era of trading, and we're lucky enough to have them on the show this week to discuss it. But what do you tell us about our guests here? Who do we have? Yeah, let me introduce them. We have

so Atlanta, Briska Loova, Anna Pavlova and Ticea Sikorskaya. They're all researchers from the London Business School and they're they're the authors of the report you mentioned, and I want to welcome all of you to the show. Thanks so much for joining us, thank you, thank you for having us.

And I want to start with you. I wanted to ask you what you saw happening with retail investor trading, what you saw happening in the space, all the mania and hype that we had been seeing back in at the start of one and what made you guys come together and start looking into this topic. We have a sample starting from November twenty nineteen going until mid the and what we so seeing that sample is a huge

growth in the trading volume in options. In fact, our data is in daily files and you can even measure this in megabytes, gigabytes, terabytes. How these files, the size of these files grow. Towards the end of the sample, we had a huge increase in retail interest during the pandemic. Then of course June July twenty we had a major peak in our data set, and yeah, it just went on from there. It's um, it's growing this volume and

it's there's no stopping for now. And Sedlanta, can you maybe talk about what exactly you guys found, because the big takeaway from me. Obviously you looked a lot into wholesalers. But the big takeaway and something I ended up writing about is the losses accrued by retail investors trading options.

Can you tell us more about that? Well, we were interested in reading, understand and what three investors do in the options market, because, to be honest, one of the big problems there is that we actually don't really have a good measure or good data will allow us to distinguish, you know, which of those trade day trades are going to be retail and which are going to be coming

from institutional investors. The only proxy is that people have been looking at before were for example, small trades when I will receive like somebody buying you know, one lord or like five lads, just you know, a little bit

of the underlying contracts. But we also know that this is not a good measure of retail trading because there is a lot of institutional investors who actually split the big orders in those tiny little bits, and so we really wanted to see what the little guils are doing because obviously we're concerned about them, and a lot of my own students, you know, the trade and financial markets, so everyone was watching game stuff and I was teaching an asset management class for them, so you know, every

session we would go back to the news and just talk what has been happening in the last three days, and every time they would be something new. UM, So naturally kind of looking at their strategies, what they do, what kind of contracts they like, and if there is a better way to identify those trades. Just exactly what you know is the core of the paper, and it was just a natural thing, you know, following all the discussions with the students. But their performance, as you mentioned,

was exactly what really UM not surprised us. UM. We do know that retail investors tend to trade a lot more and quite often they as a result, encour much larger losses, but we did not expect to see anything like this in the options market. So that focus on super short term contracts a lot really like pictures of all the payoffs and of course those massive aggregate losses during such a short period of time. That was mind

bolting for us. And the lasses are something around one billion dollars plus if you account for trading carts, it's even higher than that, right, absolutely, absolutely so, not only they basically make mistake on you know, which type of contracts, which direction you know the price is going to go, but they also underestimate clearly is a total cost got to pay for making this type of test. Yeah, and we asked the question whether their investors perhaps learned from

their mistakes. So we cut our data month by month and looked at their performance each month, and we were hoping to see that it was bad in the beginning, but it became much better towards the end of the sample. Well, we found the reverse. It was actually okay in the beginning of the sample, but then it got really bad. Well,

I see. Can I ask you to come in and talk about what actually was happening with the broader market at the time, Like how striking was it to come to this conclusion considering that we actually had the stock market overall, the SMP having a really really great year in Yeah. Sure, if you look at the return overall of let sels and if a hundred, you do see, uh,

overall good return for the thousand twenties. But then what you should also remember is that there was a huge amount of volatility at that time, and this is exactly what attracts option traders, you need to have a lot of volatility to be able to, you know, hit those very rare playoffs that clan I was talking about. And so I just wanted to say that probably an options market, you don't really need the market to go up to

have your beds working out. And that's why even now, you would not expect people to reduce this bigheraor or to stop gambling because the market is going down, because you can still trade contracts with the same way of profile. And can I also ask you, tay see what sort of feedback you guys received after the research paper came out. What were people telling you, Well, it's so far in progress, we're still presenting it in conferences, but it has definitely

received a lot of attention. When we are happy that we can attract this attention to this topic because it seems like it is important, particularly important for this new generation of retail traders. And what I find uh sort of fascinating about this topic, um is there's been a lot of scrutiny in the US towards the wholesalers or the internalizers however you want to call him, the the market makers who UH engage in payment for order flow.

I'm wondering if in this research a if if you sort of detected anything that would suggest that these players did anything that was against the rules. I mean, obviously there's a debate about whether this type of practice should be allowed or should be reformed to some degree, but

were they playing within the rules. Well, we haven't found anything, I'm afraid to tell you, but they are some facts about these wholesalers to be document For example, did you know that eighty five of payment for other flow people in options comes from just three wholesalers? Sit adele, says Quehanna, and we'll we're in. That is amazing. Yeah, And you know, there's spent a lot of talk in years past about, um, you know, options are incredibly complicated products that perhaps retail

traders should not be going near there. I remember in years past there was talk about, well, in order to actually trade options, you should have to undergo some sort of education program and pass a test that sort of thing. Do you guys think there's some merit to that is? Should maybe that be you know, the way the direction this should go, that retail traders should perhaps not be allowed to engage in this type of really risky trading

without some sort of education. First, well, during our day job, we teach students how to invest their money, and what we tell them that even if they make mistakes paying too high a fee, they should still invest in the stock market because the worst they can do to themselves is to not participate in options. There is no such thing. There is no such thing as losing on the equity premium because there is no such thing as an option premium. It's a zero some game. It's a win to some

one side and the loss to another side. So what we tell students is that they should not invest in options. Retail investors should not invest in options unless they have some risk to hedge. We have looked very carefully in our data whether the patterns we find are consistent with hedging, and tell you what not at all your speculation as

far as we can tell. While we talk a lot about the recent growth of options popularity inm on retail investors and all the technology you know, all these apps that go along with it, but it is actually also worth remembering that actually people have been trading options for not just years, but centuries, and in fact, the first ever book that was written about financial markets in six in Amsterdam is almost all about options training and it talks about exactly the same issues that we see in

the markets today, herding behavior, over confidence, you know, short term mism of the investors, and of course real underestimation of the risks of the financial art. I love that you have these facts sort of just sitting on the

top of your head. But Atlanta, I actually have a follow up for you, which is when you and I spoke a couple of weeks ago, you had told me that the type of contracts that retail investors tend to favor have sort of lottery features, and I wanted you to sort of explain that and what you mean when you say lottery like features. Well, what are the usual

features of the lottery. Um, Usually you pay a small fee to participate in this lottery in and raw to win something big, but the chances of your winning are actually incredibly small, right, So this is the type of or bet, but in this case some financial market where you pay some fee up front and then there is a small probability that you can win, but actually very

high probabilities that you're not going to get anything. And these are exactly the features of the option contracts that we find out to be really popular among retail investors. So for example, these are the contracts which are very short in terms of the maturity, like weekly options that are going to expire maybe two or three days from now.

These are the contracts they like that are going to be on the stocks that do not cost a lot of money, so the fee of participating is also quite not And these are unfortunately also the contracts on securities that have been all over the news. So it doesn't look like, you know, they're really doing it for you know, hedging purpose of doing some sort of deep analysis. It seems like they're just following whatever is trendy and try

to bet on the price going off. An I know this is this is gonna be a tough question to answer, um, but do you think, what if you have any opinions on whether this was sort of a one time phenomenon that it was a confluence of you know, people stuck at home, too much time on their hands, maybe a little too much cash, and sort of a perfect storm that created the type of environment for this type of as you say, crowd behavior and hurting or you know, is there a risk that we could see something like

this happened again sort of after you know, the traders who who lost their shirts in this round of trading, uh, you know, get some more money to trade or more traders come in. How do you think, you know, how do you think of it as as terms of risk going forward or was it just sort of one of the crazy things that happened during the pandemic And we probably won't see something like this again. Haven't we seen

something like this? Just last week? Bloomberg wrote about Revlon that's new game stop true, it's probably speaks more to just, uh, you know, that get rich quick mentality that's been been with us forever, I guess. And and this is just really a drastic example of it, of of it really getting out of control, absolutely, and it's gambling and seems

and hey, it's cheap than Las Vegas. So you mentioned that a lot of retail investors tend to favor the stocks that they see online or you know, read it as often mentioned and Twitter as well, and you had found that stacks mentioned on Wall Street, um, those that actually didn't totally pay off for retail investors. Right, So you have a list of tap losers for retail trades, and that includes game Stop and am C in your research.

But both of those stocks were stuck that were in the top five winner's basket for the market as a whole, So can you tell us about that? And you're absolutely right, you know, the common narrative was that during the time of the Game Stop, it was the retail investors that finally took control of the markets and managed to get a good profit out of those transactions. But that's actually

not what we see in the data. In fact, game Stop and AMC Entertainment, which was another really popular meme stop back at the time, they were among the worst performing contracts that the retail investors have been dealing with during the whole sample that we consider. So not only that they definitely so we've lost a lot of money

on these type of securities. But surprisingly, as they also mentioned, it's actually the transactions that were utenated by other market participants that is usually petge funds, you know, professional investors who managed to win a lot on building on options at the same time exactly the same theme stocks Jimmy and AMC, and I wonder you know, clearly the narrative in the press and the media was that this was so driven by Reddit and social media and these influential

characters on Reddit. Um. I know it's hard to sort of suss that out from just crunching through the data like you guys did, but I'm curious if if any of you have any opinions on if there's something that

should be done about that phenomenon. Clearly there were some dishonest people on social media, I believe, who tried to convince amateur new traders that you know, I remember, you know, posts about AMC is going to go to a hundred thousand dollars of share once the Hedge funds cover, you know, some ridiculous sort of notions being thrown around on social media that, um, you know, if you're a brand new trader and you get sucked into this rabbit hole. Uh,

it seems like some of them felt worth. I mean, you know, we live in a society where freedom of speech is highly valued. But is there you know, is there something you think that could be done to prevent that sort of manipulative behavior that that sort of draws people into these losing trades. That's a great question, Mike, and to bell STI also really difficult one. Um, defining kind of the rules of the freedom of speech is

incredibly complicated topic, and finance in particular. But one thing that I think it's worth always remembering for investors is that whatever you do on various forums, that does not necessarily mean that this is actually what those people implement in real life. So they could be just chip talk and a lot of the people would be, you know, talking about different strategies or the performance that, but that often has nothing to do with reality. Let me give

you one example. Back at the height of the you know, game stop Frenzy um Citadel actually released a report based on their transactions of the same retail investors that they actually implement, and what they find out is that during the week or that incredible increase in the price where the Wolstree Bad forum was all about, you know, holding too the moon and hoping that the price of Jimmy and It's going to reach all the way to one dollars, that was the time where the amount of buying investors

and selling investors was almost exactly identically. So the retail or the flow was incredibly balanced, and there was actually not much evidence that they were really not holding too the moon. So yes, forums are quite trickier, and I honestly we don't think that there is any reason to believe whatever you read them. After all, these are not financial advisors. They're not bound to you by any code

of ethic. You cannot see, Um, you know a person who's been writing, you know, some dishonest information or convincing other people to be in a certain way. The best thing is just, you know, to remember that you have to think very very careful about what to trust in terms of the information. I think only read Wildonna's stories is what you're saying, right, Definitely, That's not how the

Twitter responses I get sometimes. But T see, I want to bring you in here because a big part of what you guys were looking into where the trading costs that were associated with retail investors trading these options, and so you guys wrote the retail investors might have been underestimating the trading costs associated a bit ask spreads were super vide for retail versus the overall market. Why is that?

And can you explain that to us? Yeah? Probably it's just for us mentioning that the zero commissioned profit promise that typically comes from the broker is only part of the cost that you wear when you trade in this market. So the price that you will actually pay will not be the midpoint, you know, the uh, somewhere in between the asking and the big price in the market. UH. So, in fact, you will always kind of imagine, if you're buying a contract and then you're selling it, you will

be paying this round trip costs each time. And this is what happens in markets with such high ron over like options, and that is why investors paidous costs. And what we see is also as we mentioned before, this investors seemed to prefer really short term contracts. And imagine if you were, like, let's say, interested in weeklies on Amazon, for example, so you buy it this week and then

within the wicket will expire. But if you again want to gamble, you will buy one more contract and then one more one more, so you turn over will be pretty high, and each time you will pay around twelve percent UH with ask spread. That is what we document and the payment sure, zero commission, but twelve percent is still a lot. And I'm sure every market maker in the world is their eyes pop out their heads when they hear the a twelve percent that has spread there's

a lot of potential than the profit from that. I suppose you're absolutely right. And by the way, this spread is even higher than what you get for used cars. That tells me something about you know, how this market opulates. That's great, you can higher than used cars. I like that.

That might be the craziest thing of the week. So when we looked at payment for other flow for the very first time, we got data from all retail brokerages in the US, and what shocked us is that payment for other flow for options is so much higher than for stocks. Two thirds of payment for other flow comes from options, and you would think only a very small fraction of those retails and that there's trade options. That's how we started digging, and that's when we discovered that

twelve percent. That is surely the answer why it is so attractive to be a wholesaler in intermediating options transactions at Lana. Can I ask you about the new some of the headlines that we had seen recently about the SEC waying changes to its trading rules. I'm wanting, just like from your personal view, what you make of those Well, um, to be honest, we still are going to be waiting to see kind of the final decision on how those

changes are going to be implemented in the markets. But I think there is definitely a lot of the interest in this topic and both equities and options, and that's actually one of the reason why we think that looking at the options market is becoming more and more important because one of the points that the SEC chairman was mentioning and there isn't announcement, is that they are thinking about potentially adopting some of the elements of this trade,

how it's organized in the auctions market and then transferred into the trading in stocks, in particular the so called auctions um during which are the pricing of those contractors being determined. So we definitely need to, you know, learn more about this market, is how they operate, what's the market power of different participants, and how it all fixed together, because ultimately we need to design the system that's going

to benefit retail investors first and foremost. And there are lots of questions on which we still don't belt up really good data, really good answers. Well, so far, this attention of politymaker has been focused primarily on equities. Why equities, because these trades and equities retail trades are crossed by these wholesalers on their own private platforms. That's what internalization is. Technically, options trades cannot be internalized because all options in the

United States trade on exchanges. But what we've found is that some of these orders are effectively internalized, and they do it through the so called price improvement auctions. The wholesaler engages an affiliated market maker, and the market maker brings retail order with its own contra order and pushes

it through these price improvement auctions. Theoretically, these price improvement auctions, they have an exposure period a hundred milliseconds, which is a lot in the trading world, and other market makers can compete for these orders, but practically the fees to break these auctions are quite high, so many orders just

go through without competition. Therefore, they're effectively internalized. And Garrett Gasler mentioned that one of the things they want to do is to institute auctions like price improvement auctions we have in the options market. This is a little concerning, isn't it, because that's exactly how options orders are effectively

internalized in bright daylight on national exchange. Well, I want to actually have a follow up for you on that, which is that a lot of the talk about the new SEC rules revolved around potentially the zero commissions going away should new rules be implemented, And I'm wondering if you think that's potentially a possibility if something new does

come about from the SEC. And by the way, if I'm sure listeners can hear a kitty cat yawing in the background, she's the six member of our little talk here, which I'm I'm all in favor of. Mhm. So well, um, there payment for other flow would exist even without the actual payment for other flow for brokerages, so exchanges have been using a payment for other flow model for a long time. There are the maker taker fees, so I think effectively this payment for other flow might just move

to exchanges. So you know, people have to make money anyway. They were not going to close all the brokerages, right, so it's just they will still be payment for other flow, it just will not be all payment for other flow and will be in a different form. I think one issue that people should always remember is that there is no such a thing as free lunch on the market. So the fact that there is zero commission that means that these fees are just being paid by somebody else.

So is the question is cool? And ultimately you know which pocket is going to be the one where it all sort of don't So is it going to be, you know, through spreads, is it going to be through commissions, is it going to be through other forms of payment? And and I just to wrap things up, I want to ask you if there's something you're seeing in the market or something new that you guys have noticed or that has interested you in recent months that you're potentially

thinking about researching going forward. We see this increase in volume across the board in financial markets, not just retail trading volume, but some very sophisticated the investors trading volume, all sorts of things. So and we are wondering what's happening to this ecosystem. It this market is growing and changing. It's a big transformational change. And this is what we're trying to understand. Who came to that more kit alongside retail investors and what the ecosystem is going to look

like going forward. But first of all, Donna, I have to say, you know, this show's tradition is to end with the craziest things we've seen in markets this week. I don't think I can top something as crazy as the options trading in meme stocks. Uh that happened during the pandemic. So I'm at a loss for for a crazy thing this week. I think the whole show is kind of the crazy thing for me. It's fascinating, isn't it. It's absolutely fascinating. The first time I'll have to take

a pass on the crazy thing. That's that's that's very rare for you. It is very very rare. As you know, I'm an officiate auto of crazy. Are you feeling okay? Yeah, I might need to lie down. I might need to lie down. As Mike mentioned, all of this has been one of the craziest things that we've seen in markets in the last year, year and a half, two years.

But as listeners know, we play the craziest thing we've seen at the end of each episode, and since six months have passed so far in I know one of you has come with the craziest thing that you've collectively gathered right about markets or the economy, or something really interesting besides obviously what you've been researching that that has really uh sort of caught your caught your eyes. So c Atlanta, I'll hand it over to you and you can sort of present us your craziest thing of of

two that you've seen so far. Yes, I have one good one for you. So apparently many people already know about it, but I have literally just found out about it a few days ago, that there was a hamster called Mr Gox who would choose what type of cryptop parnce is to invest in using around in the world.

And it's really mind blowing. You know, he had live streams on Twitch that almost like eighteen thousand followers on Twitter, and um he had been performing in exactly the same way that he would sort of expect from a random hamster choice. So, you know, when the crypto market was starting, when everything was going well, or so did his beds.

And at that time, you know, there are newspapers all over the world, you know, Forbes and others are saying, you know, this is the hamster that manages to outperform more on Buffett in terms of the investors. Yeah, not surprising, right, But then obviously when the market decided to go down and as we saw those you know, absolutely crushing you know movements and the crypto exchanges as and so did

his portfolio. So ultimately over the last year he lost like cent of it starting capital or something like this, which I think it's a really good remind us that, you know, we all hear the stories about you know, there was a stock picking cat back in like two thousand fourteen, I think named Orlando. Unfortunately not the one that we heard today. Um, maybe next time. The next time. That's right, there is a kipto picking hamster. So we

all hear about the times of their success. But what you don't hear is that obviously, you know, one that random luck runs out they do of course on the perform and a loose a lot of money overall. So that's my fun factor for you guys. Yeah, now I

love it. That's perfect. I actually use the hamster as my craziest thing on an episode maybe at the start of the year, maybe it was January, I don't remember when it was, but I remember seeing an article about it and a little hamster wheel and everything, and how great the hamster had been doing apparently. And my craziest thing also actually is has to do with what's been happening in crypto. I've been fascinated by all the implosions that have been happening in the crypto space with different

hedge funds and lenders. But I wanted to point one really amazing story out from Bloomberg. Actually it's by our colleague Seek Fox, and it's it's about how how how to watch the world's biggest bitcoin hack. And it's about two I suppose alleged fraudsters who were able to very skillfully steal steal something that turned out to be worth eight billion dollars worth of bitcoin from bitfit x many

years ago, and and and they were they were caught. Uh, I believe it was a couple of months ago, and our colleague Seek just really dives into it and how it all happened and how they were able to do it. So there's lots of crazy stuff happening in krypto and with the hamster with everything, and that really that one also, that's sorry, really stuck out to me. But thank you

guys so much for joining us. I'm so happy you were able to come on and talk about everything, and hopefully we can have you back on for your next big research project. Our pleasure. It was a lot of fun. What goes up will be back next week and so then you can find us on the Bloomberg Terminal website and app, or wherever you get your podcast. We love it if you took the time to rate and review the show on Apple Podcasts, so more listeners can find us.

And you can find us on Twitter follow me at Reaganonymous. Bildanna Hira is at Coldanna Hira. You can also follow Bloomberg Podcasts at podcast What Goes Up is produced by Stacy Wan. Thanks for listening, See you next time.