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Investors embrace new options for use of options

Jan 23, 2014 @ 11:20 am

By Carl O'Donnell

There’s never been a better time to be a player in the retail options market.

Retail investors are buying options at historic rates, and using them more strategically. Meanwhile, retail brokers and options consolidators are enjoying a big boost in business, according to a report by the TABB Group.

Last year, the average daily trading volume of retail options contracts increased 12% to 3.9 million, outpacing the overall options market growth of 2.7%. Retail investors, who buy and sell securities using personal funds, now comprise 24% of listed options trading, according the January report.

The trend is expected to continue this year, increasing 5% to a daily average of 4.1 million contracts, according to the report, which was written by Andy Nybo, head of derivatives research for TABB.

One of the biggest reasons for this increase is the so-called “Great Rotation.” More investors are shifting funds out of bonds and into equities. Since options involve the right to buy or sell stocks at future dates, more equities investment means more options trading.

Retail investors have an especially good reason to increase their use of options. The derivatives offer exposure to stocks while requiring much less upfront capital. A share of Google, for example, costs over $1,000, but an option to buy that stock at a later date costs less, while still tracking the stock’s gains and losses, Mr. Nybo said.

The growth among retail investors also is connected to some quieter trends. One of the most important is the increasing accessibility of sophisticated education material about options. This includes the plethora of content on the web, as well as the efforts made by retail brokers themselves to improve investors’ knowledge of derivatives, he said.

“The last thing that a retail brokerage firm wants is an account that burns out,” Mr. Nybo said.

In the past, the most common trade among retail investors was the covered call, a straightforward move in which investors sell off the upside of a stock to make a quick profit. Today, a whole slew of complex options strategies are in use, including hedges against market volatility that involve trading multiple derivatives, Mr. Nybo said.

Equally important is the role of new technology. In an effort to attract clientele, retail brokerages provide investors with access to sophisticated trading software free of charge, with the only stipulation being that the investors trade regularly.

The software retail investors can access is nearly as sophisticated as the tools used by major institutional investors. In some cases, the retail software is even used by hedge funds, Mr. Nybo said. “The tools are leaps and bounds more powerful than they were five years ago, or even two years ago,” he said.

This boost in retail investors’ demand for options has transformed the market. Perhaps the most evident is the decline in brokerage fees. For the most active retail investors, the commission rate per option is actually cheaper than for institutional investors, at $0.10 per trade compared to $0.64, according to the report.

The main driver of this drop in price is the increasing sophistication of retail investors. Investors who trade a large volume of options know they are valuable to brokers and are not afraid to negotiate lower rates, Mr. Nybo said.

The options trading market is growing more lucrative as it grows larger, providing brokerages with a total revenue of $1.7 billion in 2013, the report said.

More importantly, the retail options market itself is running more efficiently. Retail brokers outsource the complex task of connecting options orders with exchanges to specialized firms called options consolidators.

As these brokers preside over ever larger flows of options orders, they are placing higher demands on consolidators. The result is that consolidators are scouting out better deals on trades, and improving a whole slew of auxiliary services, including technology support, market expertise and trade dispute resolution, Mr. Nybo said.

In November, options consolidators were able to find improved options prices for investors 28% of the time, compared to 19% a year earlier, according the report. The effect of all this is better functioning markets, which benefits everyone, Mr. Nybo said.

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