Impact of Increased Retail Trading Volume

I popped over to The Options Clearing Corp.’s website recently and took note of the size and scope of the impact retail traders have had on the option market. It’s amazing how all those one-, five- and 10-lot orders have made a difference. I determined that single stock options daily trading dollar value exceeded $500 billion for the first time ever. This “notional” number had been flat for years, hovering around $120 billion. It began to ramp up in April 2020, which coincided with the start of the pandemic, and ushered in huge numbers of new retail traders.

What’s the big deal and why am I writing about it? Because this volume is changing the complexion of the underlying company’s share price and therefore the corresponding options prices. Developing traders should be able to determine how and why this phenomenon impacts markets. Understanding this relationship provides the keys to profiting and/or avoiding getting run over by a surprising share price movement or a seemingly inexplicable options vol pop (a rather uncomfortable experience best avoided when possible).

Below I define some key terms I feel are important to understand because of current volatility levels, along with some commentary about how they matter to traders.

Open Interest

This number simply represents the quantity of outstanding options contracts. OI, as it’s known, is broken down by strike, and by call or put if you know where to look. While the top line OI number doesn’t necessarily reveal much, at a minimum it can be tracked to determine if interest levels are increasing or decreasing in a given security, in a particular month, strike, etc. Growing OI indicates a healthy market that makes it favorable to trade.

There are many tools you can use or vendors that offer insight into OI that can help you make heads or tails of open interest data. Being able to “read the paper,” as we used to say on the floor, is a skill one can develop that can help with recognizing trends in volatility and determining the most accurate “fair” or theoretical value of single stock options.

Pin Risk

This term represents the concern that a stock’s share price will close near the strike price of an option in which one is holding a position at expiration. This fear is warranted mainly (but not exclusively) for traders who hold a short position. It comes because the trader with the short position does not know whether the trader with a matching long position will exercise or not. This means they don’t know whether they will be assigned from a short options position they held resulting in an unwanted residual stock position.

Having shares “called away” from them, or “put” into their account as a result of being assigned, is anathema to an experienced trader. It’s been known to cause risk managers to howl, dreaded margin calls and, of course, realized losses due to uncooperative price action when the stock opens for trading on Monday morning.

Recently, there have been several outsized share price moves that seemed to come out of nowhere (to the untrained eye). As it turns out, expiration-based activity (see “pin risk” above) caused by increased retail trading volume is the culprit. Significantly increased volume in at-the-money options has caused some notable whippiness to the chagrin of many traders. The reasons can be explained with a little bit of a deeper dive.

Retail options trading generally consists of call buying. Market makers are obligated to sell those calls. A large percentage of the calls retail traders purchase are considered at the money, or close to the current share price. As expiration day approaches, the elevated open interest level becomes more of a concern because the impact on the options greeks grows acute.

Market makers understand pin risk is a real thing and realize that they have exposure, so they try to avoid it at all costs. Since these are experienced and smart traders, they actively delta hedge their positions to mitigate the risk in their portfolio.

However, an unwanted result sometimes occurs in that this “good” hedging inadvertently adds an additional layer of risk. Hedging activity can exacerbate the underlying stock’s price moves resulting in choppiness, unpredictability and ultimately pain. Short gamma is the culprit, since the market makers must engage in unwanted negative scalping to maintain an acceptable level of risk with respect to their position’s delta.

When retail traders alter the balance of risk/reward, it upsets the apple cart of “normal” trading activity resulting in surprising losses due to otherwise unexplainable share price volatility. Being keen to these situations as they happen can save your bacon.

Call/Put Volume

Call/put volume is simply the number of calls/puts that traded hands on any given day. There is a lot to be derived from the C/P volume as it’s known on many trading platforms. Does the volume show more call buying or put selling, or vice versa? Is the volume spread around the board, or is it concentrated in only a handful of names? As has been the case recently, 61% of the total number of options traded in July 2021 have been in a handful of recognizable companies. These are Tesla, Amazon, Apple, Google and Nvidia.

An even more telling story is that 89% of all C/P volume has been in the top 50 companies. Smart traders recognize that certain securities are better suited than others for their style of trading. Consistently high C/P volume usually attracts more market makers to a security.

A bonus for retail traders emerges as a stock becomes more crowded and that bonus is tighter markets. Trading options with tight bid/ask spread markets can save a trader thousands of dollars a year, simply because they don’t have to give away as much premium to market makers.

A recent trend resulting from increased retail activity is that market makers are sometimes overwhelmed by the sheer volume of all those one and two lots that keep hitting the tape. What happens as a market maker’s position begins to swell is that they will start to shy away from adding to the already large position they’ve taken.

This “fading” of their market can result in a curious phenomenon I’ve noticed recently that bears mentioning. What occurs in the options markets when retail interest is exceeding large is that implied volatility will increase in a given strike, while the actual volatility of the underlying security remains the same or even decreases.

Final Thoughts

It’s worth it for developing traders to note the C/P volume and open interest numbers when a condition as described above is happening. Traders should always be on the lookout for rare times when options implied volatility is exceedingly high and not justifiable based on historical, let alone actual, volatility of the underlying. Inefficiencies in options markets are rare and fleeting. However, during particularly volatile periods, as we have been experiencing lately, such opportunities abound and can be exploited.

Joe Leska, Market Taker Mentoring

Trader Education