Options trading activity hits a record driven by retail investors, but most are playing a losing game

Stock options have grown in popularity on Main Street this year as a growing number of retail investors began executing high-speed trades in derivatives, but most of them are playing a losing game due to a lack of access to more complex strategies.

A record 39 million options contracts were traded on average daily this year, up 35% from 2020, according to Options Clearing Corp. Private investors account for more than 25% of all options trading activity, thanks to easy access via the commission-free online offering, according to the Alphacution Research Conservatory.

An overwhelming majority of these small traders buy the simplest call and put options, which have a much lower probability of winning compared to more advanced strategies that may not be easy for investors to understand, such as option spreads.

For example, 11% of Robinhood’s monthly active users made an option trade in the first three quarters of 2021. Meanwhile, less than 1% were executing a multi-leg option trade that involved two or more transactions at the same time.

“Everyone in the industry knows that if you just buy calls out of the money, you will likely lose money over time,” said John Foley, CEO of Options AI. “The question of democratization should not be: Can I trade options? but ‘can I have direct access to the option strategies that Wall Street uses?’ The playing field is not even at the moment and nobody really focuses on it. “

Options are a form of derivative contract that gives buyers the right to buy or sell a security at a certain price at some point in the future. A multi-leg options spread trade involves buying and selling options on the same underlying security at the same time, a common method of hedging against risk. These multi-leg strategies can be a bit cheaper because the proceeds the investor earns from selling the option offsets part of the cost of the option.

Here is an example of various Tesla options trades based on real-time prices on Tuesday lunchtime. In this case, a typical retail investor pays more for bets with a lower chance of winning when there is a cheaper option spread with a higher probability of winning.

Most popular brokers have between three and five tiers of options trading that they give investors access to based on their trading experience, income, and risk profile. For example, option spreads – where multiple options are used to hedge risk – are not available to most investors until they reach Level 3 Wall Street pros have benefited from them for decades.

“The Robinhood investor is the newbie among retail investors,” said Paul Rowady, research director at Alphacution Research Conservatory. “The question is, how do I influence new, often very young, first-time investors with a smooth and highly gamified application? their revenue model. “

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Robinhood earned $ 164 million from options trading in the third quarter, more than tripling its transaction-based stock trading income. The brokerage firm had 22.4 million accumulated net accounts in the third quarter, up from 22.5 million in the second quarter.

“Of course we know that options are not for everyone, and unlike some other brokerage houses, Robinhood does not allow short selling or trading uncovered options,” said a spokesman for the popular trading app. “Over the past year and a half we’ve improved our options selection criteria, added more educational content on Options both on our Learn website and directly in the app, improved our option displays, and introduced 24/7 live phone support through the app.”

1 million trades per day

The surge in trading activity in retail options is most evident in what are known as meme stocks. Earlier this year, a legion of retailers tied to online chat rooms managed to create massive short squeezes on names like GameStop and AMC Entertainment by amassing those stocks and call options.

The Cboe analyzed the total customer volume in the top 15 meme stocks on its four options exchanges based on the original order size.

In January 2021, at the height of meme stock mania, option trades with order sizes between 1 and 10 hit more than 1 million trades per day in the top 15 meme stocks, and that number continues to rise through the end of 2021, with options contracts representing 100 Shares of the underlying security.

The increased involvement of retail investors in options trading has caught the attention of regulators.

The financial industry regulator will be issuing a request for comment in the coming weeks to gain insights into options trading and the risks involved from exchanges and brokers, a spokesman told CNBC.

Finra said it was considering whether changes to option rules could be warranted, including rules for option account approval, supervision, and margin requirements.

- CNBCs Nate Rattner contributed to this story.