How Retail Investors Stack Up Against the Professionals
(5 min read)
(5 min read)
In the 12 months to April 2021, the S&P500 increased 82%. That is a lot – the highest YoY rise in over 80 years. And unlike the events of 1936, retail investors were well positioned to cash in. Many did, with trading volumes for call options on both small and large stocks surging in early 2021.
The surge in retail investor participation has had a noticeable impact. Earlier this year, the US Securities and Exchange Commission had to suspend trading in the shares of certain companies on the back of social media discussions. Many also blame greater price volatility and market dislocation on their rising involvement.
Yet empirically proving retail investors behave substantially differently to market traders is hard. This is because few situations exist in which the two groups are held separately. One example, however, is the so-called Mini options market, which existed between 2013 and 2014.
In essence, by offering a tenth of standard options, the Mini options market created a natural separation between investors on a budget and the rest of the investor community. This allows a new Journal of Banking and Finance paper to compare the behaviour of retail investors against standard option traders. They find:
Broadly speaking, retail investors appear more spontaneous in their trading decisions. Rather than searching systematically, they tend to consider only stocks that first catch their attention. And retail investors’ buying pressure surges when stocks are ranked as daily winners or daily losers.
Retail investors are also easily influenced by attention-grabbing events. Trading around, for example, earnings announcements is mainly speculative and mostly dominated by small traders. Specific to options markets, retail investors buy more calls than puts on attention-grabbing days, leading to lower hedged returns.
Retail investor behaviour is also predictable. Most appear to do research overnight, causing overnight returns to be higher than intraday returns. Also, stocks with higher overnight returns over the last month tend to have higher overnight returns in the subsequent month too.
The authors use intraday option transaction data from LiveVol, containing information on the stock, option type, expiration date and strike price. The sample includes 0.6mn transactions of Mini options, which were available on the five most popular and high-priced securities: Apple (AAPL), Amazon (AMZN), Google (GOOG), SPDR Gold Trust ETF (GLD) and SPDR S&P500 ETF (SPY).
Notably, while Mini options only covered five securities, the tickers represented around a quarter of the trading volume of the entire options market from 18 March 2013 to 31 December 2014. Between them, 57% of transactions took place in AAPL, 16% in GOOG, 13% in AMZN, 9% in SPY, and 5% in GLD.
The authors also collect information on 26mn standard option transactions, which have a trading volume of around $187bn. Traders in the standard options market had different preferences from retail traders in the Mini options market. Between the five tickers, 43% of transactions took place in SPY, 37% in AAPL, 8% in GLD, 7% in AMZN and 5% in GOOG.
The authors split each trading day into five-minute intervals from 09:30 to 16:00 and calculate the dollar trading volume of a ticker in each. They find clear evidence that volumes are highest in the first five minutes of the day, with 7-8% of trades occurring then (Chart 1). While standard options traders follow a similar pattern, just 3.5% of total trading volume occurs during the first five minutes.
Price pressure exists if demand pressure increases the price of options. The authors test whether Mini options prices and volatility are different from those of standard options at different times of the day. They are. Mini options experience larger demand pressure during open intervals, which induces a larger price deviation of Mini options from the corresponding standard options.
With more intense trading leading to higher prices of Mini options in the morning, could there be an impact on intraday option returns? There is – the authors find the intraday returns of Mini options are significantly less positive compared with standard options in four of the five stocks/ETFs. In other words, that retail traders can devote less attention to their trades during the day lowers their intraday returns.
Next, the authors look at the trading activity of retail investors and standard option traders around major events. During earnings announcements, they find trading volumes are 15% higher for Mini options traders compared with 11% for standard investors. The day after a ticker is ranked as a winner or loser (in the top 80 or bottom 80 in the CRSP universe), retail trading volumes increase 16-17%, compared with 10-11% for standard options traders. The results show retail investors are enticed to trade during attention-grabbing events.
The results are exactly the opposite for attention-distracting events, like the Boston Marathon bombing or Moore Oklahoma tornado. For such events, the authors find Mini option investors reduce trading activity by 4% compared with 0.3-0.7% for standard investors. In essence, distracting events divert Mini option investors’ attention such that they reduce their trading activities more than standard option investors.
A common measure of investor sentiment is the C/P ratio. If the value is 0.5, investors have no preference between call and put options. A value higher than 0.5 means investors prefer call options, signalling bullish sentiment.
The mean C/P ratio for the Mini options market across all tickers from 2013 to 2014 was 0.63, 10% higher than that of corresponding standard options. This indicates that compared to standard option investors, Mini option investors are more likely to buy call than put options.
Broken down by ticker, retail investors are especially more likely to buy SPY call options. With standard options investors tending to buy put options on the SPY to protect against market downside risks, this means retail investors are failing to protect themselves enough to profit more from upward market movements.
Next, the authors relate time variation in the C/P ratio to the ‘Daily News Sentiment Index’ from the Federal Reserve Bank of San Francisco. They find the relation between the C/P ratio and sentiment index is significantly stronger for Mini options, indicating retail investors are much more likely to follow the market sentiment.
Lastly, the authors compare the trading performance of retail investors and standard option investors. Specifically, they explore the order imbalance and future returns in Mini options to see whether retail investors experience positive or negative payoffs. On this front, they find that the order imbalance in Mini options significantly predicts the option return of the next trading day with a negative sign. That is, Mini option buying is associated with lower next-day returns.
Retail investors are constrained in how much attention they can devote to their portfolios because most have work commitments. Sadly, this disadvantages them and, according to the paper, noticeably impacts their returns. It pushes them to trade at the start of the day, inflating prices and hurting profits. It reduces their ability to respond to new information, and the information they do obtain has already caught the attention of many other investors. All-in-all, retail investors have a tough life, and finding the edge is tricky!
Li, Yubin., (2021), Trading behavior of retail investors in derivatives markets: Evidence from Mini options, Journal of Banking & Finance, vol. 133, no. 106250, https://www.sciencedirect.com/science/article/abs/pii/S0378426621002090