(Bloomberg) -- With the meme-stock army in retreat and crypto fervor cooling, the booming marketplace for stock options proved a lucrative substitute for US retail brokers last year.
Now the explosion in short-term derivatives trading is showing no signs of easing, a boon for major online brokers as they gear up to report earnings.
Demand for speculative options helped spur a more than $2 billion revenue haul in 2022 as market makers paid out beefy commissions to retail brokers, including Robinhood Markets Inc (NASDAQ:HOOD), to execute their orders.
That’s an overwhelming chunk of the total $3 billion paid out by likes of Citadel Securities and Virtu Financial (NASDAQ:VIRT) for routing day-trading flows their way across markets from equities to options, according to a Bloomberg Intelligence analysis of Securities and Exchange Commission filings.
Short-expiration derivatives in particular have gained popularity among Reddit investors looking to ride the global market turbulence, including bullish bets on the S&P 500 that mature in just 24 hours.
Since bid-ask spreads on equity options contracts are typically wider than those on regular stock trades, wholesale trading giants and brokers are able to extract big profits from the retail crowd, through the controversial practice known as payment-for-order flow.
“Broad adoption of options trading by retail investors has been to the benefit of online brokers such as Robinhood and Schwab that take payment for routing such orders to market markers,” wrote Neil Sipes, an industry analyst at Bloomberg Intelligence, in a report last week.
The SEC in December suggested changes to the way some equity market orders are handled in a bid to increase competition and transparency. Yet derivatives flows have received much less regulatory attention and options are largely absent from key changes proposed by the agency at the end of last year.
That’s despite the rise in their popularity and the opaque structure of the market, all of which makes executing options contracts particularly profitable.
With options demand proving strong in the new year, brokers may be expecting the good times to endure. Speculative traders have gorged on single-stock call contracts this month at an unprecedented clip, in the global risk rally attributed to bets on a soft economic landing and a tentative pause in Federal Reserve policy tightening.
Online brokers have seen options trading steadily become a bigger revenue stream post pandemic as the industry enjoys a boom in retail participation. Last year, the business got a further boost as day traders retreated from the cash market, turning to derivatives for gambling wagers. That’s proving a boon for firms who are able to charge more on these opaque products in part due to the fragmented nature of the marketplace.
“For each stock, there’s dozens of call and puts at various strikes and expirations,” said Jackson Gutenplan, a senior analyst at BI. “With trade activity dispersed across much more products, liquidity is worse and bid-ask spreads are wider.”
All told options trading represented more than 70% of the $700 million of payments for orders in the last three months of 2022, up from 60% two years earlier, according to BI data. Broker reports increasingly show options are providing an outsize portion of revenues, despite their modest daily volumes relative to the buying and selling of single stocks.
Charles Schwab (NYSE:SCHW) derived 65% of its revenues from PFOF from options in the fourth quarter, up from 57% in 2020. In the third quarter, 60% of Robinhood’s transaction-based revenues came from options. The brokerage gained fame in the pandemic for offering zero-commission trading that turbocharged risky bets from stay-at-home traders. It will report its fourth-quarter earnings on Feb. 8.
Meanwhile meme stocks are back in vogue at the start of 2023, giving Main Street’s brokers fresh earnings opportunities.
Yet some academics suggest that retail traders are losing out dearly. An academic study published last year, titled “Retail trading in options and the rise of the big three wholesalers,” estimated investors lost more than $2 billion, excluding fees, during the pandemic boom. It cited bad market timing — and super-wide spreads on their options of choice, among other factors.
“Options, by design, make one side the winner and the other the loser,” Svetlana Bryzgalova, who co-authored the paper along with Taisiya Sikorskaya and Anna Pavlova, in an interview. “The only one who consistently wins in our study is the wholesalers, retail traders always lose.”