Everyday Traders Lost Big on Meme Stocks

A new study showed the total net losses by retail traders to be over a billion dollars, but it gets worse...

The Rise of the Day Trader

While stuck at home during the pandemic, many at-home investors turned to trying their hand at trading markets, many for the first time ever. Urged on by Reddit posts TikTok influencers, the "army" of retail traders pushed daily trading volume to new records, with some posting screengrabs of massive gains.

FOMO - fear of missing out for those not chronically online - pushed many amateur traders to seek lottery-like returns: short investments with chances at doubling, tripling, or even getting 10x return on their money. However, like the real lottery, the odds were always tilted away from the investor's favor, and in the long run, the little guy lost. So how did it all unfold, and just how much did they lose?

The Call is Coming From Inside The House

At-home investors sometimes bought-and-held stocks like Gamestop and AMC theaters, but many turned to options contracts. These are securities that let the buyer pay an up-front premium to make a big bet on the direction of an underlying security, like a stock. So, for example, you could pay $200 to buy a call option on Gamestop, and be rewarded handsomely if the value of the stock went up. Volume in these bullish contracts set record after record as stuck-at-home tinkerers flocked to the contracts in an effort to juice up returns.

Though the narrative was largely around the regular mom-and-pop investors banding together to outsmart the hedge funds and big institutions on Wall Street, researchers Svetlana Bryzgalova, Anna Pavlova and Taisiya Sikorskaya estimated that retail investors lost $1.14 billion trading options from November 2019 to June 2021. Most of this gain, ironically, went to big financial institutions and hedge funds on the other sides of these bets. Even worse, trading costs chewed up another $4.13B of traders money.

This last number became a point of contention, even in Congressional hearings. Retail trade brokerages like Robinhood introduced zero-cost trading by wiping out commissions and other brokerages soon followed. There is, however, no such thing as a free lunch in finance. So how did Robinhood make up the money lost from giving the service of trading away for free? They get something called payment for order flow. In short, some big financial institutions are so comfortable taking the other side of regular individual trader's bets that they pay the brokerage a fee for being able to route that order. This can lead to the trader paying a huge hidden cost in execution of the trade. Since brokerages like Robinhood gamified trading to induce more of it, this cost in execution ballooned to more than 4 time the actual investment losses.

Traders Lost Out Double, If You Count the Alternatives

Maybe most stunning is that the market during this period racked up impressive gains, even accounting for a 35% Covid-induced decline during the first quarter of 2020. An index of the top 500 stocks rose more than 40% between November 2019 and mid-2021. It wasn't just a few names either; 3 industry sectors were up over 50%. Retail traders that were broadly invested in the market made out excellently while active traders on the whole lost big.

A Few Key Takeaways

1. Neither the researchers of the study mentioned above nor OnlyFunds ever recommends trading options to individual retail investors. It's a very quick way to lose a lot of money, and like at casino, the odds are that the pros will take it from you.

2. OnlyFunds goes a step further to recommend investing, not trading (check here for how we do it). Most people's best chance at building wealth through investing is not going to come as a get rich quick trade. It means the (boring) discipline of:

   1. Building good saving habits like setting up recurring deposits from your checking to your investment account.

   2. Buying and holding your investments, not trying to trade.

   3. Starting early, even if its small. Remember, its about time in the market, not timing the market.

   4. Let the pros handle it for you. If you find yourself needing to scratch that trading itch, take a small percentage of your money to play around with yourself, and give the rest to a manager.

3. If it seems too good to be true, it probably is. All that "free" trading in Robinhood may sound good, but traders are paying a hidden price for it.