Options Trading Is Rigged Against Average Investors; Payment for order flow allows brokerages and big traders to team up against the little guy. Alex Yin - Bloomberg Would you gamble your life savings on a few hands of blackjack? Probably not. But as a former manager of options trading, I've seen amateur investors - encouraged by posts on Reddit and X of massive, easy overnight wins, and offers of "zero-commission" trading online - lose much of their net worth on risky bets. What bothers me most is that some big trading firms are actually paying brokerages to take the other side of these trades, knowing they have better information than the small investors and so will profit big. These payments are known as "payment for order flow." In 2022, large trading firms including Citadel and Susquehanna paid a total of $2.9 billion to brokerages such as TD Ameritrade Corp. and Robinhood Markets Inc. to trade against their customers' orders, according to SEC data compiled by Alphacution Research Conservatory. In short, they are paying for the privilege of taking advantage of the unsophisticated investor. /jlne.ws/3Tc7AtC
Options Trading Is Rigged Against Average Investors Payment for order flow allows brokerages and big traders to team up against the little guy. December 7, 2023 at 6:00 AM CST By Alex Yin Alex Yin is a student at Stanford Business School and was an options trader for Optiver and Chicago Trading Co. Not a retirement plan. Photographer: Brent Lewin/Bloomberg Would you gamble your life savings on a few hands of blackjack? Probably not. But as a former manager of options trading, I’ve seen amateur investors — encouraged by posts on Reddit and X of massive, easy overnight wins, and offers of “zero-commission” trading online — lose much of their net worth on risky bets. What bothers me most is that some big trading firms are actually paying brokerages to take the other side of these trades, knowing they have better information than the small investors and so will profit big. These payments are known as “payment for order flow.” In 2022, large trading firms including Citadel and Susquehanna paid a total of $2.9 billion to brokerages such as TD Ameritrade Corp. and Robinhood Markets Inc. to trade against their customers’ orders, according to SEC data compiled by Alphacution Research Conservatory. In short, they are paying for the privilege of taking advantage of the unsophisticated investor. This is akin to a few Vegas casinos paying travel agents to send them droves of unsophisticated players. The travel agent, like a brokerage, is paid by volume, and so wants to promote as much betting as possible. Other casinos, like the trading firms that don’t pay for retail orders, would have reduced access to these profitable inexperienced players. Trading by retail investors has recently reached as high as 60% of the total market volume in options, according to new research by Svetlana Bryzgalova, Anna Pavlova and Taisiya Sikorskaya of the London Business School, with dollar volumes increasing by more than 10 times in the last decade. (The firms I worked for did not pay brokerages for orders, but benefited from increased volumes in retail trading.) And the surge is only accelerating. Last May, exchanges started listing options that expire on each day of the week rather than three days, and they have exploded in popularity.With the potential of making 50 or even 100 times your investment in a day, they are the cheapest and fastest way to potentially win big, the biggest dopamine hit available for sale on the exchange. According to research at the University of Münster, 75% of retail’s S&P 500 option trades today are of this variety. For seven years I ran options strategies at large trading firms, so I understand that options trading can make you rich, fast. But even though many players claim a winning strategy, the vast majority lose money. I quickly learned that the small bettors tend to choose the worst investments. And the house always makes money. Buying an option provides you the opportunity, but not the obligation, to buy or sell a stock at a certain price. Let’s say a stock is trading at $100, and you think the price will go up. You might pay $5 for the right to buy the stock for $110 at any point in the next six months. If the stock doesn’t reach $110, the option expires, and you lose $5. If the stock goes to $150, you make $45 on only a $5 initial investment. If our model said an option was worth a dollar, we’d buy when the price hit 99 cents or sell for $1.01, collecting the invisible theoretical penny difference. We repeated this process with thousands of different options, every time a customer wanted to trade. Those small amounts added up to big ones. Roughly a dozen other trading firms used similar strategies, competing to offer the best price to the customer. Collectively, we made up the house. This can be highly lucrative: In my last three years running the desk, we didn’t have a single losing month. Several other firms post equally impressive results each year. The most important rule of market making: Not all customers are the same. Sometimes, shrewd hedge funds had better information than us and also had enough money behind them to move the market in their favor. Trading against them would be a losing proposition, so we avoided these orders. On the other hand, customers trading small sizes consistently lost money. They had no informational advantage, and their orders could never move the market against us. Taking the other side of these trades was highly profitable. Supporters argue that platforms like Robinhood allow everyday people access to profitable strategies. However, research at MIT indicates that retail traders lack enough private information to win. And according to London Business School research, buying $100 of the popular “zero days to expiration” options would cost up to $6 to $12 just to enter the position. Little surprise then that retail traders gave up an estimated $6.5 billion in trading cost between November 2019 and June 2021, even though most paid no direct commission to their brokerage. What can be done to protect them? First, regulators should prohibit payment for order flow, creating a level playing field where all trading firms can compete by offering the best price. Regulators should also continue to penalize dubious advertising practices that platforms have used to attract uninformed options customers. In 2021, the financial regulatory body FINRA fined Robinhood a record $70 million for “systemic supervisory failures,” accusing the company of allowing users to make riskier trades than they were qualified for. Robinhood continues to present the riskiest options — the ones that expire almost immediately — to the user first in the options trading menu, without any mention of their dangers. How can retail investors beat these odds? As with blackjack, it’s generally best to avoid the table altogether. Or to deposit small amounts, understanding you are gambling, not investing. Buying low-cost index funds is still the best way to build long-term wealth. The S&P index has returned an average of 7% a year after inflation since its inception a century ago. Only 10%-15% of professional fund managers manage to beat the market over a decade. Now that I’m in business school, I no longer have troves of live market data or algorithms to instantly react to market news. Trading professionally made me recognize just how much of an information disadvantage I am at now. Instead, I stick with much simpler investments, and small investors would do well to do the same.
I don't buy into the spin of the article. I just consider PFOF as a necessary function for contract creation. Unlike shares of stock, there is not a fixed supply of option contracts that can be traded. The notional value of all of the contracts traded can far exceed the market cap of the stock. The tail may be wagging the dog, but someone with deep pockets needs to take the other side of the trade, else the market would be much smaller, and less liquid with much wider Bid/Ask pricing.
It is very NY Post of them to use the term "Rigged." I'm not a big fan of PFOF but you need equity and option market makers to add depth and liquidity. Without them markets would be very wide or there can be no market at all. My biggest issue with market structure is the fragmentation. IMO, 16 Option exchanges owned by a small number of exchanges and an endless number of ECNs and Dark pools takes away time/price priority. IMO, all the Option markets owned by CBOE, Miami, NYSE and NASDAQ need to be consolidated. Send your order to any exchange you want, but if not executed, every order should drop into one order book, with time/price priority. That means if I'm the first one to bid $1.01 for an option, I should get filled before anyone else at that price does any. This would encourage both market makers and customers to show their best price. Right now, with directed order flow and 16 option markets, there is little incentive for market makers to narrow markets and very difficult for customers to buy on the bid or sell on the ask without markets going against them. The directed flow to a DMM can be routed to an exchange around that order or the DMM can match.
The more I read about trading options the more I feel like I should shave my head, go to the nearest mountain and start singing to the birds with a cheap ukelele. PFOF is a well known problem for retail trading. That well known that brokers don't give a f*ck and rip everyone apart on a daily basis.
why is this a problem? market makers are saying retail traders are so dumb, they will pay your commissions to trade with you. You are smart, so let them pay your commissions for you. They still have to show your order to the market when they realize you are smart. Being a FIRM sucks. There's a guy on here whose strategy ended because he was considered a FIRM. He's very smart.
As a retail trader, nobody is forcing you to buy or sell your option at the absolute worst price. Market makers make the bid and ask spreads on options as wide as possible because that is how they make their monies. So, if you were trying to sell your options and you see the market maker low balling his bid price, you only need to wait another 2-3 days to get out at the price you want or even higher. Remember, the market maker takes both sides. So, any options he buys at cheap prices, he is going to sell to the traders at high prices when he closes out those options to pocket the profits. Just align your options orders with the market maker since, they have the deeper pockets.