Trading among retail investors has soared during the pandemic, sparking the meme stock frenzy that has sent names that were favorite short positions among hedge funds, like GameStop and AMC, through the roof. More recently, retail investors have discovered options trading, and the numbers show that more and more of them are trading options.
However, regulators fear retail traders are biting off more than they can chew when it comes to trading options. Today, a fund manager who focuses his trades on options has some advice for retail investors who want to trade them.
Record options trading activity in 2021
According to Options Clearing Corp, an average of 39 million options contracts will trade every day in 2021, setting a new record with a 35% increase over the previous year. Data from Alphacution Research Conservatory shows that retail investors accounted for more than a quarter of trading activity, thanks to the easy access provided to them by online brokers who charge no commission on trades.
CNBC reported in December that the vast majority of these retail traders were buying the most basic put and call options. However, the problem with this strategy is that these types of options have a significantly lower probability of making a profit compared to the more advanced strategies used by hedge fund managers like Wayne Himelsein, Chief Investment Officer of Logica Capital.
According to CNBC, 11% of monthly active users on Robinhood traded at least one options contract during the first three quarters of last year. However, less than 1% executed a multi-leg options trade, which combines two or more trades.
Tips from Logica Capital’s Wayne Himelsein on options trading
Himelsein is known for his mean expansionist approach to the markets. Most investors enter the markets expecting stock prices to generally average or return to normal. However, Himelsein takes the approach that many price moves are likely to continue rather than revert to the mean. With this in mind, he looks at options investing in long and short directional bets.
In an interview, Himelsein says that options are “not as fantastic as they seem”, which means that several variables influence them, but investors are not necessarily aware of all these influencing variables. When investors buy options, they think they’re betting on a stock moving in one direction and how big that move will be, but it’s not that simple.
“So when they’re buying a call option, what they don’t think about in this amateur world is that options are priced based on volatility,” Himelsein says. “So if the stock price is going up, but volatility is going down, the two forces are working against each other, and that’s reflected in the muted payout.”
He used the example of earnings reports as an illustration, saying it’s not uncommon for stocks to go up or down 20% during an earnings event.
“So people, in their minds, think that’s a fantastic use of options, but it’s not because the volatility is against them,” Himelsein said. “…Going into earnings, volatility is on the rise and long calls are sold at a very high price. If the stock exceeds earnings estimates and then rises 10%, they may be ecstatic because they got it right, but it’s not right after the earnings event as the volatility crushes the upside.”
Himelsein adds that once it’s all over, they may end up stagnating and not understanding why when the stock is up 10%. He explained that in this scenario, the volatility dropped so much that it influenced the price of this option more.
“My best advice and thought for emerging options traders is to also assess the value of volatility alongside their exploration of the underlying [stock price] movement,” he added.
What types of options to use when
At Logica Capital, Himelsein tends to buy more call options on individual positions and focus more on the broader market on the downside with put options on the S&P 500 and other broad indices. However, he said there are also times when it makes sense to buy put options on individual companies or sectors, such as the potential upside behavior of individual positions when things have already fallen dramatically.
As stated earlier, Himelsein sometimes uses pairs. For example, when the planes crashed into the World Trade Center towers on September 11, he had paired a long position in Lockheed Martin with a short position in Boeing. Both are airline manufacturers, but Lockheed Martin focuses more on defense, while Boeing focuses more on domestic and international travel.
“The market was closed for five days, and when it reopened Boeing went down and Lockheed went up,” Himelsein said. “I made a fortune on this pair. It stuck in my head. I could have been in the exact opposite and incorrect position for the crisis event that had just occurred.”
Of course, no trader wants to be positioned with options in the wrong place at the wrong time. As a result, Himelsein tends to participate more in downside indices and take individual bets for the expected upside.
“When things go wrong in the world and all the correlations go to one, whatever title you’re in, you suffer,” says Himelsein. “When there is a crisis and everything goes down, everyone panics and starts selling everything everywhere to get cash. For this reason, we like the behavior of the index more in the downturn, because it extracts the risk basic.”
FINRA concerned about investor protection
Regulators have become concerned about the significant increase in options activity among retail investors and the likelihood that most of them will lose money using the most basic options contracts.
CNBC reported last month that regulators are now starting to worry that retail traders are getting in over their heads with trading options contracts. The Financial Industry Regulatory Authority (FINRA), which regulates all US stock exchanges and brokerage firms, has issued a notice to its members to remind them of the risks of options, qualifying them as “complex” products.
The regulator also reminded its members of their legal obligations to ensure that their investors are investing in products that suit them. He said “significant regulatory concerns arise when investors trade complex products without understanding their unique characteristics and risks.”
FINRA also announced that it is seeking comments on whether the regulatory framework currently in place protects investors. She pointed out that these rules were originally adopted when investors purchased most financial products through professionals. However, many of these products are now marketed through self-managed platforms such as Robinhood.
FINRA’s opinion does not only cover options. Instead, the regulator groups together several financial products under the term “complex”, describing this new category as “a product whose characteristics may make it difficult for a retail investor to understand the essential characteristics of the product and its risks (including including the payment structure and how the product can work in different market and economic conditions). »
Himelsein is torn apart by new regulations.
“I see the benefit in it of protecting investors from mischief, and at the same time I feel like the best way to learn is to try and fail and study where things have gone. gone wrong,” he said. “I guess a middle ground for this kind of thinking would be for regulators to allow activity but somehow limit the amount, such as prohibiting more than a certain dollar amount on products complex. This way, new traders can learn and get a feel, but not destroy themselves in the process!”
This proposed category could include leveraged and inverse exchange-traded products, structured products, volatility-linked ETPs, and defined-income products. AND F. All of these products provide exposure to the performance of a market index while providing downside protection and capping gains over a period of time. Mutual funds and ETFs trading crypto futures could also be included.
FINRA is also asking if it should put in place more requirements for trading these products to protect investors. Specifically in reference to “self-managed platforms”, the regulator asks if “additional guardrails are required for these types of platforms”. She also asks whether retail investors should be required to take tests to demonstrate their understanding of these “complex products” and their risks.
Michelle Jones contributed to this report.