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

• A record of 39 million options contracts have traded daily on average this year, rising 35% from 2020. Retail investors now account for more than 25% of this trading activity.
• However, the majority of these small-time traders are buying the most basic call and put options, which have a much lower probability of profit compared to advanced strategies like options spreads.
• "Everybody in the business knows that if you're only buying out-the-money calls, then you're likely going to lose money over time," said John Foley, CEO of Options AI.

Stock options gained popularity on Main Street this year as a growing number of retail investors started executing high-speed derivative trades, but most of them are playing a losing game given the lack of access to more complex strategies.

A record of 39 million options contracts have traded daily on average this year, rising 35% from 2020, according to Options Clearing Corp. Retail investors account for more than 25% of total options trading activity, due to easy access via commission-free online brokers, according to data from Alphacution Research Conservatory.

A staggering majority of these small-time traders are buying the most basic call and put options, which have a much lower probability of profit compared to advanced strategies that may not be easy for investors to grasp, such as options spreads.

For example, 11% of Robinhood's monthly active users made an options trade in the first three quarters of 2021. Meanwhile, fewer than 1% executed a multi-leg options trade, which involves two or more transactions at the same time.

"Everybody in the business knows that if you're only buying out-the-money calls, then you're likely going to lose money over time," said John Foley, CEO of Options AI. "The question of democratization shouldn't be 'can I trade options?' but 'can I have straightforward access to the options strategies that Wall Street uses?' The playing field is not level right now and no one is really focusing on that."

Options are a form of derivative contract that gives buyers the right to buy or sell a security at a chosen price at some point in the future. A multi-leg options spread trade involves buying and selling options of the same underlying security simultaneously, a common way to hedge risk. These multi-leg strategies may be slightly cheaper because the proceeds the investor makes from selling the option offsets some of the purchase cost.

Here's an example of different trades using Tesla options based on real-time prices during midday Tuesday. In this case, a typical retail investor is paying more for bets with lower chance of profit when a cheaper option spread with a higher win probability exists.

Most popular brokers have between three and five tiers for options trading that they grant investors access to based on their trading experience, income and risk profile. For instance, options spreads — which involve using multiple options to hedge risk — are not available to most investors until they graduate to level 3. So, essentially, new traders have to learn options by trial and error at first before they can use strategies that Wall Street pros have profited from for decades.

"The Robinhood investor is the most novice of the cohorts of retail investors," said Paul Rowady, director of research for Alphacution Research Conservatory. "The question is how do I influence new, often very young first-time investors using an application that's frictionless and highly gamified? How do I get them to try options where based on the payment for order flows, these fees are a vey lucrative component of their revenue model."

Robinhood generated $164 million from options trading in the third quarter, more than tripling its transaction-based revenue from equities trading. The brokerage had 22.4 million net cumulative accounts as of the third quarter, down from 22.5 million in the second quarter.

"Of course, we know options aren't for everyone, and unlike some other brokerages, Robinhood does not allow short selling or uncovered options trading," a spokesperson for the popular trading app said. "Over the past year and a half, we've enhanced our options eligibility criteria, added more educational content on options both on our Learn website and directly in the app, improved our options displays, and introduced 24/7 live phone support through the app."

1 million trades per day

The surge in retail options trading activity is the most prominent in the so-called meme stocks. Earlier this year, a legion of retail traders glued to online chatrooms managed to create massive short squeezes in names like GameStop and AMC Entertainment by piling into these shares and call options.

Cboe analyzed all customer volume in the top 15 meme stocks on its four options exchanges by the original order size. 

In January 2021 at the height of the meme stock mania, options trades with an order size between 1 and 10 reached more than 1 million trades per day in the top 15 meme stocks, and that count continues to climb into the end of 2021. One option contract represents 100 shares of the underlying security.

Retail investors' increased engagement in options trading has garnered the attention from regulators.

The Financial Industry Regulatory Authority will publish a request for comment in the coming weeks, seeking insight from exchanges and brokers about options trading and the risks involved, a spokesperson told CNBC.

Finra said it's considering whether changes to the options rules may be warranted, including rules around options account approvals, supervision and margin requirements.

— CNBC's Nate Rattner contributed to this story.

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