A Real Cost of Free Trades: Retail Option Trading Increases the Volatility of Underlying Securities
43 Pages Posted: 13 Mar 2023
Date Written: March 9, 2023
We examine the link between retail trading in options and the volatility of the underlying assets. Using Robinhood's introduction of options as a shock to retail trading, we confirm that option volume increased around this event and show that volatility similarly increased for: interlisted US securities, relative to their Canadian counterparts; optioned shares relative to optionless shares for firms with dual class shares; and more so for shares that would be become more attractive to retail traders as a result of the fee change (relatively high stock prices or low option prices). We provide further evidence suggesting the effect is permanent and that the underlying mechanism is related to market makers hedging their option exposure: volatility increases more for shares with higher option-embedded leverage; spreads and price impacts are lower; market maker volumes increase; and the volatility of retail option volume increases. Our results suggest that a shift in retail trading toward options drives an increase in the volatility of the optioned securities due to that actions of market makers hedging their exposure.
Keywords: Retail traders, Options, Robinhood, Volatility
JEL Classification: G01, G12, G13, G14
Suggested Citation: Suggested Citation