Vol 2, Issue 10. Quarter 4 – 2025.

“What I want to talk about is Retail Options Trading; also known in some circles as degenerate gambling.”  Ben Felix

If you don’t know who Ben Felix is, I highly recommend his Rational Reminder podcast (Rational Reminder) I am not sure I would have included the word “degenerate” in that statement, but he does have a point. Options are financial contracts and are useful tools for risk management and hedging. For example, consider your position as a senior executive in a large corporation holding a major position in your company’s stock. You would prefer to be more diversified, but if you sell a major portion of those holdings the press will scream that you “don’t believe in your own company.” This will have a major, and negative effect on the stock’s price and hurt yourself and the firm. So you may prefer to sacrifice some “upside” by spending money to put a lower limit on the stock’s value in your holdings. This is a perfect opportunity to create a contract so that if the stock price drops too far, someone else has to absorb that loss. That is one of many reasonable uses for options trading.

However, most retail (read do-it-yourself) investors do not use options in this way.  Furthermore, there are two major complications that most of us don’t fully understand here, and you should never invest in something that you don’t understand. Let’s deal with these two elements in turn.  The first is known as “embedded leverage”. Let me elaborate with another simple example. Let’s say that you sell a call option on stock XYZ with a strike price of $100 and a closing date of 12/25/25. Just for fun, let’s also assume that the current price of this stock is $95, and you can sell this option on 100 shares for $100. You just made $100 today. Woo hoo!!!!

The question is, what happens on 12/25/25, when the option matures? As long as the price of the underlying stock is $100 or less – the answer is nothing. You keep your $100 and go on with your life. On the other hand, if the stock price rises above $100 by some amount X, you effectively are forced to pay $100 * X. If X = $10, you pay out $1000. If X = $20, you pay $2000, and so on. The point is that the most you can make is $100, and the most you can lose is Infinite. You gained the payment of $100, but you carry the risk of having a price increase on 100 shares.  You didn’t actually borrow any money, but your obligation to cover the gain on 100 shares is equivalent to borrowing money to buy 100 chances to lose money. That is why the buyer was willing to give you the $100 to start with.

“Hey dumbass – I saw 3 guys last week who made a killing trading options. You are just a hater!!”  Random Reader

Which one of us is Actually Biased?

Yawn!! I won’t defend myself from such a weak claim, but I do suggest you consider a simple story. About 30 years ago I ran into a fellow at my local bookstore who was doing a talk about how drinking cabbage juice cured his prostate cancer. (No, this is not a joke.) He told me that his diagnosis suggested that he needed to have his prostate removed, and he didn’t want to do that so he found some “alternative medicine.” I explained that he probably found an “alternative” to medicine that has been proven to work, but he wasn’t interested in that argument. He went on and did his talk with great enthusiasm and gusto and received a grand ovation at the end.

Here is the problem. If you get a cancer diagnosis and chose to do nothing, you will probably die. But the key word is “probably”. Some percentage of such patients will recover naturally, whether they drink cabbage juice, or pray to the sun-god, or break-dance on the sidewalk. The 1 or 2% that recover will then travel the world proclaiming the benefits of their chosen cure-all. The other 99 people who tried the same trick, don’t say a word .  .  .  because they are dead. This is the literal meaning of the term “survivorship bias.”

If a million people get cancer and do nothing about it, 1% (or 10,000) of them will fully recover. You then have 10,000 people selling various juices, creams, pills, powders, potions etc. In fact they will feel that their approach is “proven” by the presence of the thousands of people who demonstrate the benefits by being alive. The problem is that for some odd reason none of the dead folks say a word. Its pretty easy to drown out the advice of the dead because they are so quiet.

What does that have to do with this post, you ask? Simple – the small percentage of options traders who do well, shout from the rooftops about how great it is, while the other 99% keep their mouths shut, hoping that their luck will turn in the near future. By the way my 99% estimate is very close to the actual numbers.

A Few Winners and a Whole Lotta Losers

Since you don’t want to believe me, consider this. A recent paper in the journal Management Science (https://doi.org/10.1287/mnsc.2023.4916) found by looking at every option trade made in the market in South Korea over a 4 year period, that the median retail investor lost about $5000 over the period. In fact, the retail investor at the 70^th percentile just broke even, meaning that the bottom 70% of retail investors lost money. This is not including any taxes that may have been incurred along the way. (By the way, I was only able to publish 1 paper in this journal so far. So I speak from a bit of experience when I say that this journal is as good as it gets, in terms of research quality.) The same work found that the median institutional investor showed a gain of about $8000. Of course, the retail investors greatly outnumber the institutional investors, even though each retail investor is moving smaller amounts of money at a time. This all suggests that the professional investors made money at the expense of the do-it-yourself class.

In addition, the researchers found a way to classify the trading styles of the parties involved. Let me quote that work at some length.

Based on the dominant strategy, we categorize accounts into the most significant trading styles as follows: (i) combination traders, (ii) bullish simple strategy traders, (iii) bearish simple strategy traders, (iv) simple strategy switchers (who switch between bullish and bearish simple strategies), (v) long volatility traders, (vi) short volatility traders, (vii) volatility switchers, and (viii) spread traders. 

Taking this a step further, they found that “volatility sellers significantly outperform the benchmark in both average return and Sharpe ratio.” Finally, they find that “volatility trading is the dominant strategy in 4% of institutional accounts and 5% of retail accounts.” I state these facts to make a simple point. If you do not understand the details of each of these trading styles, and specifically, if you do not fully understand the nuances of “volatility trading” you are simply not qualified to trade in this space. I feel quite confident in saying that this statement applies to at least 90% of the people reading this post as well as the vast majority of people day-trading options.

Other research in the Journal of Banking & Finance  found that in their sample, options traders incur much larger losses on their investments than equity traders. (We post a pdf of the paper on our Documents page.) They state, “The gross return difference between these two groups of investors equals more than 1% per month.” They also found that, “for the US market our finding that single men with low income and little investment experience trade most suggests that gambling and sensation-seeking are important determinants of option trading.” In other words the people getting lured into retail options trading are largely men with relatively low incomes and low levels of investment experience. Again, this suggests that the folks looking to “make $100 a day” after 7 or 10 minutes of training are losing money to the larger, more sophisticated investors.

To be more explicit, they found that “the average option investor loses 1.81% per month in gross terms during the sample period.” Now, I am not sure what types of returns you are looking for, but I am pretty sure that -1.8% per month, ain’t it.

Spreads Cost Money

In addition to the issue if implied leverage, we have to also consider the risks and costs associated with the lack of liquidity in this market.  Let me explain. Stock prices are quoted as though they come from a single number at every moment in time. However, this is an incomplete depiction of what is going on. For every share of stock at every point in time there is a Bid price and an Ask price. The Bid is the highest amount that a buyer has stated that they are willing to pay. The Ask is the lowest price at which a seller has stated that they are willing to sell. In the vast  majority of cases the difference, known as the Bid-Ask spread is not a big deal. For broadly traded shares in highly liquid markets, this is likely to be 1 or 2 pennies per share.

However, research has found that the Bid-Ask spreads on many of the shares that amateurs trade options on have average spreads closer to 12%. What does this mean for you? When you sell a call and it is exercised, the buyer may effectively force you to buy shares to satisfy the terms of the contract. Let’s say a stock is shown to have a price of $100, and you have to buy 100 shares to make good on a contract. If the lowest Ask price on that share is $112, you really have to pay $112 per share to make good on your contract. This spread becomes a hidden part of your cost. Again, if you do not fully understand how this works, I would strongly advise you not to trade in this space.

Let me be clear. This is not to say that you cannot learn the ins and outs of this game. But it does seems pretty clear that you are not going to get all of this from your 7-10 minute training program. I am also willing to bet that your grandmother told you many years ago something like – “if you don’t understand it, don’t buy it.” But putting that sort of “mother-wit” aside this is a tremendously dangerous game to play for at least 4 reasons.

1. You don’t know the level of expertise of the person on the other side of the contract.
2. The upside of many positions is capped while the losses have no limit.
3. The strategies most likely to make money are beyond the understanding of the average trader, and
4. The costs are multi-dimensional and many of the largest ones are hidden.

But these are not the greatest problem involved. Stay on the alert for our next post, as we dive into the 2 truly diabolical aspects of this game.