By Jon Light, Senior Director of Product Management, Devexperts
The recent growth of retail options trading demonstrates that a sizable contingent of retail traders has graduated to derivatives that were once reserved for a professional class of investors. However, these instruments are not only riskier for individual accounts; they also have the ability to alter underlying market dynamics.
Retail options are growing
Retail participation in US options markets has been nothing short of remarkable in recent years, aided, no doubt, by increasingly accessible app-based platforms and the introduction of shorter expiries.
The high watermark of this activity was reached in July of 2022, when retail traders accounted for 48% of overall options activity. The unique situation at the time may have provided an artificial boost, but by July of the following year, retail had almost managed to reclaim that highpoint, accounting for around 45% of the overall market 1.
Retail now accounts for 56% of options that expire in less than five days, up from 35% in 2019, as well as 42% of all options that expire on the same day 2.
How they affect markets
Options aren’t just an institutional instrument that has found favor among a retail crowd. As seen above, with the explosion in short-dated positions, products geared specifically toward retail preferences are increasingly being approved and launched.
This is leading to the market having to adjust the ways it manages risk in these instruments, which is a big change from how institutional order flow was handled in the past.
These markets now move faster and are much more sensitive to asset price rates of change. This can cause intraday price action to spike during periods of increased volatility. Heavily traded strike prices approaching expiry must be hedged more frequently, leading to feedback loops in which price action is artificially amplified, as was seen during the pandemic with the WallStreetBets phenomenon.
Increased retail participation can also have the opposite effect, constraining implied volatility contrary to underlying fundamentals when retail participants write options to collect premium during periods of subdued price action. This can squeeze implied volatility and overshadow fundamentals in the underlying securities in question.
Options are more than just another product in a broker’s offering; they alter the dynamics of underlying markets, something that previous generations of retail traders couldn’t hope to do. Market participants and regulators are still adapting to these changes.
How brokers can help
Brokers have become highly adept at streamlining the on-boarding process to bring new traders in. This influx of new non-professional options traders may be more than their legacy tools are able to supervise. However, there’s a lot that can be done on the broker side to guide newcomers so as to highlight the associated risks and protect them when they first start trading.
The ease at which retail traders can now access options markets and implement specialized options strategies via simple platform presets necessitates a higher level of awareness regarding what’s at stake, as well as the implementation of certain guardrails on the back end to allow new traders to learn without taking on undue risk.
A good start is to educate traders about how options risk is non-linear, compared to stock trading, where risk is linear. Traders should be made aware of how options allow large amounts of leverage to be applied, and to show how this can easily blow up a newcomer’s account in comparison to stock trades gone wrong.
Beyond client education, it’s advisable that brokers offering options to non-professional investors utilize the backend tools now available to limit what they can do when they first start trading options markets. For instance, pre- and post-trade margin logic and bespoke rules can be defined and applied beyond those that regulators oblige them to implement. These practices can help protect newcomers and ease them into the instrument.
Furthermore, highly complex worst-case scenario modeling, which is not required when trading spot assets, is now available to retail options trading platforms. To offer options trading without access to these features is to democratize these highly complex non-linear markets without the benefit of the data necessary to understand the true risks involved.
Brokers intent on entering the space are called to consider the full cycle of approvals, pre-trade checks, event risk, and post-trade monitoring that the instrument demands if they wish to create a dynamic where retail traders can access these markets without being at a disadvantage.
Monitoring new retail accounts, creating and applying custom brokerage rules, offering pre-trade controls for multi-leg orders, and helping traders manage assignment and expiry risk are all things that retail brokers offering options can implement right now to protect retail traders, while also easing the pressure this sizable group of participants now exert on the wider market, until a more formalized response is mandated by regulators.
References:
