Retail Trading in Options and the Rise of the Big Three Wholesalers

Bryzgalova, Svetlana; Pavlova, Anna; Sikorskaya, Taisiya

doi:10.2139/ssrn.4065019

Cited by 5 publications

(3 citation statements)

References 46 publications

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“…Two working papers use options trade-level data. Bryzgalova, Pavlova, and Sikorskaya (2022) use price improvement auctions to identify retail trades, and show retail traders fail to optimally exercise calls before dividends. Hendershott, Khan, and Riordan (2022) examines price improvement auctions theoretically and empirically, and argues option auctions are consistent with creamskimming, having lower price impact than limit order book trades.…”

Section: Literature Reviewmentioning

confidence: 99%

Payment for Order Flow And Asset Choice

Ernst¹,

Spatt²

2022

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Financial technology has drastically expanded access to the stock market. Today, a retail investor can effortlessly trade stocks on a smartphone, access news on social media, and pay zero fees for either service. While the automation of trading has been a decades-long process, the coronavirus pandemic further accelerated this evolution. Robinhood, LLC (a zero-commission brokerage firm) currently reports 18 million users, and earns over 80% of its revenue from payment for order flow (PFOF). These are payments from market makers (such as "Citadel") to brokers (such as "Robinhood"), on the condition that the broker privately routes orders to the market maker, rather than to the public markets. This practice has raised a series of concerns from both market participants and the U.S. Securities and Exchange Commission (SEC), which has a mandate to maintain fair, orderly, and efficient markets. The first concern is that these trades may not receive the best prices. The second is that the practice of routing customer orders away from markets may lead to wider bid-ask spreads on exchanges. The third is that retail brokerages will have incentives to encourage excess trading.Across all these concerns, our paper highlights a novel cross-asset difference between stocks and options. In equity markets, we find that broker routing to wholesalers also benefits retail equity traders, as wholesalers offer smaller bid-ask spreads than the exchanges. Moreover, this occurs even when exchange spreads are at the minimum allowable width, in which case PFOF cannot be leading to artificially wide spreads. In option markets, we find the opposite result: broker routing to wholesalers harms retail option traders. Thanks to quasi-randomized assignments of Designated Market Makers (DMM) across options exchanges, we are able to show that PFOF-paying DMMs are causally associated with wider bid-ask spreads. When we look at the PFOF payments made directly to brokers, we show that a similar cross-asset difference occurs: routing options trades pays brokers substantially more, both in aggregate and per-share, than equity trades. Brokers have more than just an incentive to encourage excess trading of any asset, rather, they have a particular incentive to encourage excess trading of options.This cross-asset difference is magnified by the zero-commission trading environment. From SEC Rule 606 reports, we estimate the typical PFOF paid to a broker for routing a 100 share options trade at 40 cents, while the typical payment for routing a 100 share equity trade is around 20 cents.

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Section: Literature Reviewmentioning

confidence: 99%

Payment for Order Flow And Asset Choice

Ernst¹,

Spatt²

2022

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“…On the contrary, as suggested by Easley et al (1998), a significant level of uninformed trading is necessary for market makers to be willing to engage in trades. The recent rise in retail trading in options markets is examined in Bryzgalova et al (2023) andde Silva et al (2023). Their empirical results suggest that retail options traders fit the return profile of noise traders.…”

Section: Introductionmentioning

confidence: 99%

Lever up! An analysis of options trading in leveraged ETFs

Gilstrap,

Petkevich,

Teterin

et al. 2024

Journal of Futures Markets

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We examine options trading in leveraged Exchange‐Traded Funds (ETFs) and their impact on the performance of the underlying funds. Using implied volatility innovations in call and put options, we demonstrate that option signals from leveraged ETFs are robust predictors of the underlying ETFs' performance. While both levered and unlevered option signals forecast ETF returns, the levered signal is more pronounced in both magnitude and relevance. This predictivity power primarily stems from inverse leveraged ETFs and during economic downturns. Furthermore, we use the leveraged ETF option signals to develop a trading strategy that produces an average abnormal performance of 1.13% per month.

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“…There was some transfer of volume from the equity markets to option markets. The Bryzgalova et al (2022) paper is a comprehensive documentation of retail trading with focus on short term options, price improvement, and payment for order flow. One of their many findings is that retail investors prefer cheaper, weekly options.…”

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confidence: 99%

The GameStop short squeeze: Put–call parity and the effect of frictions before, during and after the squeeze

Hilliard

2023

Journal of Futures Markets

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The short squeeze in GameStop attracted worldwide attention and resulted in congressional hearings. The increase in GameStop stock from an opening price of $21 on January 26 to an interday high of $483 on January 28 was not the result of obvious fundamental earnings prospects. Buying pressure from investors on a social media site accompanied by short covering, resulted in the stratospheric ascent of stock price. We use put–call parity to investigate the related issue of the no‐arbitrage violations before, during, and after the squeeze. We do not find evidence of abundant free money after accounting for short selling frictions.

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Retail Trading in Options and the Rise of the Big Three Wholesalers

Cited by 5 publications

References 46 publications

Payment for Order Flow And Asset Choice

Payment for Order Flow And Asset Choice

Lever up! An analysis of options trading in leveraged ETFs

The GameStop short squeeze: Put–call parity and the effect of frictions before, during and after the squeeze

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