How Retail Investors Lose Money in Option Trading
quantpedia.com
quantpedia.com
Those people lose money because they either have no idea how options work or are just really really bad at it. Or they see a stock jump 500%+ in a week and then buy high.
Some of them simply treat options like a slot machine.
Individual investors can beat professional investors, though it's hard to do. I have seen no evidence showing individual investors outperforming when using non-linear derivatives. Utilitarian buyers of options treat it as insurance. They expect to lose money. There are fundamental reasons a market maker will be able to manufacture options at a cheaper price than an individual, ranging from cost of capital to the benefit of a book to order execution times and settlement dynamics.
People say that hedge funds are worse than passive investing, and that's often true, but it's true because that's after fees - professional investors routinely beat the market by 3% YoY long term averages, it's just that they are basically paid as much as they make you.
Source? (It’s not true for common definitions of those words.)
Most hedge funds won’t touch options for the reasons I mentioned. They’re a hedging tool. (They will happily use swaps and other leveraged instruments. But those are linear.)
It's going to be fairly difficult to give a source, though.
Sorry, it was my turn to be imprecise.
Most hedge funds aren’t taking exposure through options but managing risk with them. Most asset managers never touch options. Most professional money managers (institutional; I’m not counting FAs) are not at hedge funds.
Well, how would you get to see that evidence? I mean, it'd have to be a non-zero number of them.
It would be uninteresting if it said that the pros beat the amateurs. But it is interesting in that the pros are not trying to beat the amateurs. Instead, the pros have very simple strategies at play here, and the amateurs are blundering:
1. The amateurs seek to buy options before announcements they think will trigger big moves even though the spread is high (rationally, if the spread is high, you should be a little worried since it increases the risk you can't close what you open at a desired price)
2. The announcement happens
3. The amateurs hold their options despite their desired direction not occurring
4. This amplifies their losses
So, overall, as a retail trader you could do these very simple things:
* Be afraid of big spreads
* If you traded expecting volatility and the big announcement happened and the outcome you wanted didn't, cut your losses and leave
If retail investors want to lose their shirt gambling on options, that's their choice, but it's certainly not true that "the pros" always beat "the amateurs".
Market makers make money by offering spreads. EG: fair price of a stock is $1, market makers let you buy that stock at $1.01, and sell for $0.99. Hence, if you buy and sell, while the market maker is paying $1, they make $0.01 on both sides of the trade because they are marking up the price.
In options, the spread can be quite extreme, more than 30% of the price of the underlying (eg: you can buy for $0.60, or sell at $0.20, which means purchasing such an option and you are down by over two thirds out of the gate).
Market makers balance positions by delta hedging and/or simply connecting trades. That means the direction of the market does not matter to them, market makers are not at all trying to make money off of market moves (they are making money by providing liquidity).
The 'connecting trades' example is common and easiest to understand. For example, one person is buying 100 shares, another is selling 100 shares. Both orders go to the same market maker and they are just connecting those two trades together. The time the market maker is actually holding shares is miniscule.
A slightly more complex example of the same kind of "connecting trades" is one person selling 1000 shares and ten other people buying 100 shares. Market makers will connect these trades as well, they'll buy the 1000 shares and then almost immediately (talking milliseconds) sell the 100 shares to the 10 buyers. They can turn around very quickly because the orders are queued. Sometimes trades will not execute right away even though it is well within a reasonable fill price, and that could be simply waiting for liquidity (eg: if someone is selling 10,000 shares, a market maker might do a partial fill if they can only found buyers for 1000 shares, in which case only 1000 shares are traded and the order would stay open for the remaining 9000 shares).
In this kind of 'trading' done by the market maker, there is almost zero risk, they are providing liquidity.
Though, not all trades can be connected together, which is a less desirable position for market makers in which case they create 'delta neutral' positions (positions that do not change in value despite any change in price of the underlying asset).
For example, let's say you are selling a call contract and there are no buyers. A market maker can still buy this contract from you without being exposed to delta risk. They would do this by buying the contract and then exercising it (creating a long position of 100 shares). At the same time, they open 100 shorts of the same underlying, creating a position with 100 long shares and 100 shorts, a net neutral position. Shares from exercising options are allocated by a clearing house after the trading day closes (5pm ET). This means when the market market actually gets the 100 long shares, that cancels out their 100 shorts and the position is closed. Meanwhile they were able to provide liquidity and allow someone to sell a call contract even though there were no buyers, and they were able to do so without any risk from moves in the market by creating a "delta" neutral position (any changes in price increase or decrease are offset between the long and equal short position).
Market makers do only make a best effort to provide liquidity. For example, if a market maker can't or won't open an offsetting short position, this is a place where there is no liquidity at all and you simply won't be able to execute your trade for any price (there is no market for that contract).
That matches my first order academic understanding of market makers, but not the more detailed work I've read, or the work of the QRs at the handful of market makers I've spoken to/worked with.
It didn't seem like connecting trades were a particular focus of the people I've spoken with- is that something that happens off exchange? My understanding is that would happen automatically on the exchange, and that primarily market makers connect trades across time, pocketing bid/ask spreads but accepting risk of adverse price movements while they hold that position. To mitigate that risk, they do a bunch of signal analysis to set the spreads low enough to be competitive, high enough to mitigate that risk. Some market makers famously pay and provide price improvement for small/uncorrelated orders from retail brokers. I was told that that was specifically because of the reduced risk of adverse market movement from retail orders.
Market makers are generally required to always provide buy and sell prices, or risk fines/losing their market maker status on an exchange, right? Those prices might be extremely unreasonable (e.g. in a flash crash setting sell prices to 9999999), but if there's a market maker, there is required to be a price at which they will execute a trade, whether or not they can hedge that risk or now.