Cooped up at home by stay-at-home orders during the anxious early days of the pandemic, many people used their newfound free time and stimulus checks to pick up a new hobby. Some turned to fitness or learning to play an instrument, while others found a rather unhealthy and risky new side hustle: day trading. Inspired by stupendous returns posted on Reddit’s WallStreetBets and TikTok by random influencers, with a helping hand from zero-commission brokerages, many started dipping their toes into the stock market.

But what was astounding was that many of these novices chose to buy some of the riskiest and most obscure derivatives on the financial market: call options with a less than a week expiration date. Unsurprisingly, most lost a boat-load of money. Who knew wagering against established money makers is asking for it?

A new study, for instance, released by economists at the London Business School put figures to the pandemic market blood bath, showing that U.S. retail investors drawn to the frenzy lost $1.14 billion trading options between November 2019 and June 2021. The bill jumps to $5 billion if you also consider the trading costs of doing business with high-volume market makers, known as wholesalers, whose fees are not directly obvious to investors new to the market.

A lottery disguised as an investment

Day trading is a style of trading in which positions are opened and closed typically during the same trading session. The day trader makes a profit if the closing price is higher than the entry price or, when they take short positions, by selling at a higher price and then buying at a lower price.

Day traders will speculate on the price fluctuations of various financial instruments, including stocks, bonds, and commodities. But one of the most popular financial instruments among retail investors has been options — contracts that allow you to buy or sell a certain number of shares at a specific price, known as the strike price. When trading options, you must close the trade within a predetermined date, called the expiration date.

There are basically two types of options: calls and puts. Call options give you the right to buy a stock at the strike price on or before the expiration date, whereas a put option allows you to sell a stock at a specific price on or before the expiry of the contract. Each contract covers 100 shares of stock.

The more volatile a stock, the higher the chance for stupendous returns. This explains why some of the most popular day trading stocks during the pandemic were Tesla, whose valuation ballooned from $50 billion to over $1 trillion between 2019 and 2021, and the meme stock GameStop, which caused so much disruption in the market it prompted a Congressional hearing. But high volatility also means the trader risks losing the premium paid for the options contract — and the bill can add up quickly.

Enticed by the potential returns of day trading options, retail investors, many in their first months or even weeks of trading, jumped on the bandwagon. And since these unsophisticated investors typically lack capital, they prefer lower-priced, but more speculative, options with short maturities (i.e. contracts expire within a week).

In order to measure the performance of options day traders, London economists Svetlana Bryzgalova, Anna Pavlova, and Taisiya Sikorskaya investigated transaction-level data received by U.S. retail brokerages like Robinhood from so-called wholesalers. They were astounded to find small retail investors were buying more than 23 million call options a week during the peak of the mania in 2021 — that’s almost four times more than in late 2019.

Although options holders are not obligated to buy or sell the underlying stock, they will lose the substantial premium they paid for the contract. And many times, the kind of options small retail investors chose to buy were incredibly irrational, akin to buying lottery tickets. For instance, Bloomberg reports that during the GameStop mania, more than 50,000 calls that wagered the stock would surge sevenfold within 24 hours changed hands during a single day on February 25, 2021.

That example is particularly shocking because it goes against every risk management principle that seasoned traders on Wall Street live by. One such principle is to only bet money you can afford to lose so that you have enough capital to regain your losses when the market reverses to an upside. Without sound risk management, traders are vulnerable to consecutive losses or sizable individual losses that are too large compared to their overall financial position. This is why successful traders use risk management tools, such as stop-loss orders, using fixed percentage position sizing, and stress tests.

Retail investors also lost money because they were generally unaware of the hidden fees they were paying for their options. The researchers found that the average bid-ask spread for calls and puts with less than a week to expiration was a stunning 12.3%. Every time they bought an option, the traders incurred this indirect cost that can be substantial as hundreds or thousands of trades mount up. So although the contracts are “cheap” nominally, they are in fact expensive and financially unsustainable for the day trader.

What’s particularly damning about these findings is that most American day traders lost a lot of money during a “bull market” in which the S&P 500 rose more than 40% from November 2019 to mid-2021. If you had simply bought and held an index fund tracking the S&P 500, you would have made a great return. Meanwhile, options day traders bought a bunch of lottery tickets.

“They lose money on average and participate in frenzies. The inflow of retail investors also coincides with an increase in call options left suboptimally unexercised. Arbitrageurs exploit these investor mistakes via so-called “dividend play” trades, producing (virtually) riskless arbitrage profits. Puzzlingly, they forgo 50% of these profits, leaving money on the table for option writers,” the London Business School researchers wrote in their study published in the journal SSRN.

Are lockdown investors here to stay?

Retail investment boomed to a trillion-dollar business during the pandemic virtually worldwide, as millions of people flocked to the “sugar rush” drawn in by a social media frenzy. Although they knew little to anything about investing, that didn’t stop all sorts of regular people to open a broker’s account and start trading.

In an interview for the BBC, 18-year-old Richard Jones from Penrhyn Bay, Conwy county, UK, said he worked part-time at Home Bargains in early 2020 when he decided to invest all his spare income into stocks.

“In January, I was getting quite bored during lockdown and I needed something new to get into, and I wanted to find a way of making my money work for me,” said Richard.

“I was up quite a bit at one point, then down quite a lot. Now I suppose I’m up £400,” he said in July 2021.

Others, like 41-year-old marketing manager Nicola Knight from Llantwit Fardre, Wales, dived deep into day trading.

“For me, trading is a purpose to get a cash flow that is coming in as supplemental income. So, we live our normal lifestyle from our normal income and then any money we get from trading goes into a separate pot,” Knight told the BBC. “Ideally, I want to buy properties at auction or in cash so that there’s no mortgage on them, which will be for our retirement.”

These are illustrative case studies from a new generation of lockdown traders. According to the Financial Conduct Authority, UK customers opened 7.1 million new investment accounts in the first 12 months of the pandemic — that’s a striking figure for a country numbering 54 million people over the age of 18.

Like in the US, many in the UK turned to day trading options, as well as other derivatives, such as futures and forward contracts. Futures are financial contracts that allow a trader to buy or sell an underlying asset, such as a stock, without actually owning it. Like options, futures allow you to get exposure to the market with a much smaller investment than having to buy the position outright on the spot market; have an expiry date; are traded through exchanges; can be used for speculative purposes or to hedge other position.

The main difference between options and futures is that futures come with an obligation to buy or sell the underlying asset in the future when the contract expires, whereas an option provides the right — but not the obligation — to buy or sell the underlying asset at the strike price. Meanwhile, forward contracts are basically the same as futures, with the notable difference that futures are traded through an exchange, whereas forwards are solely traded “over-the-counter” through a broker.

But retail investors’ appetite for derivatives seems to have waned since the peak of the pandemic now that the market has made a turn for the worse. According to Reuters, Lloyd’s, which is the biggest bank in the UK, has seen a steady decrease in the inflows of new retail investments across its platforms, while the vast majority of the smaller investment platforms in Britain are now posting losses. Robinhood, a pandemic darling, posted a 43% fall in quarterly revenue in April 2022 and laid off a tenth of its staff. Robinhood’s ($HOOD) stock is also more than 75% down from its all-time high.

However, even though many retail investors got burned, with many likely never to return, they still comprise a sizable group. Perhaps, even a force to be reckoned with by historical standards. In October 2021, JPMorgan estimated that retail investors accounted for about 20% of all trading volumes in the US, down from 25%-30% at the peak of the meme stock mania in January and February 2021, but still much higher than the typical 10% to 15% before the pandemic.

Options traders were particularly busy, with average daily volumes of such derivatives in the third quarter of 2021 doubling compared to the 2019 average.

“Retail investors are a force not just in gross terms, but directionally they’re turning out to still be a powerful force of buying today,” Peng Cheng, a global quantitative and derivatives strategist at JPMorgan, told the Financial Times.

It seems like at least some of the new lockdown retail investors may be here to stay. Let’s just hope those who’ve lost a lot of money actually learned from their mistakes and are wiser participants in the market.

This content was sponsored by CMC Markets.

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