June 27, 2024

Episode 311 - Is Roaring Kitty a Good Role Model?

June 27, 2024

When witnessing the dramatic payouts of miracle trades, it's easy to be lured into thinking that your big score is just a few trades away. But as is evident in trading options for retail investors, it is neither quick, simple, nor easy to make guaranteed returns on your investments. In today's episode, Ben and Cam walk us through the many reasons why trading options is a losers’ game; especially for retail investors. Trading options is definitely today's hot topic and we unpack how the recent resurfacing of Roaring Kitty affirms how life-changing payouts are the exception rather than the rule. We dive deeper into trading options and their uses, the trading demographics of the current market, why trading options are an expensive choice for retail investors, and why people still choose to trade even when doing so at a loss. To end, Ben and Cam highlight the dangers of being a copycat and how social media adds fuel to the fire and we hear some heartwarming Rational Reminder Podcast reviews from a few of our dedicated listeners.

Key Points From This Episode:

(0:00:48) Why today's topic is widely discussed in the current financial climate.

(0:03:34) What we can learn from the resurfacing of Roaring Kitty.

(0:05:35) A brief background on stock options and their various uses and the current state of retail trading.

(0:08:13) Understanding the trading demographics at play in today's markets.

(0:10:24) Discussing why trading options are expensive for retail investors.

(0:12:35) Why people keep trading despite losing on average.

(0:16:16) Exploring the dangers of copying successful traders and the role of social media.

(0:17:17) The after show, headlined by inspirational Rational Reminder Podcast reviews from you, our dear listeners.

Read the Transcript

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to Episode 311. The third person, Mark, who's normally here is actually on vacation this week. So, we're kind of getting back into the original groove here. We get to have Mark back in a couple of weeks. This week, the topic you chose pretty interesting. Why don't you queue it up?

Ben Felix: Jump around the topic?

Cameron Passmore: No. I want you to queue the topic up, and then we'll jump in after.

Ben Felix: Oh, sorry.

Cameron Passmore: You're rusty.

Ben Felix: Sorry.

Cameron Passmore: Yes, people, Ben is rusty.

Ben Felix: The main topic that I have set up is, anyone that pays attention to financial markets has seen that a roaring kitty kind of reappeared, made some pretty serious trades on GameStop, and it's a whole bunch of interesting stuff happened there. But the main thing I wanted to talk about was, more generally speaking, does trading options make sense for retail investors. Because I think a lot of people see what Keith Gill, aka Roaring Kitty has done and see –

Cameron Passmore: Wow.

Ben Felix: – look at all the money he made with his trades. Maybe I can do that too. So, we're going to talk a little bit about the data around that.

Cameron Passmore: Cool. So, before we get to that, I wanted to share a little story. I was talking to Ben on the advice team this week, and he was telling me some examples of people that have reached out who were referred to us by listeners of the podcast. Because something I suspect you hear as well, Ben, but I hear it fairly often from people, they say, "Why do you do the podcast like this?" Because if people are into the podcasts, they are probably not necessarily ideal prospects or clients for us. That's not the main reason why we do the podcast, our objective is to put information out in the world.

But what we found and we had several examples last week, where people called for variety of reasons, saying they needed help with some planning or some investment item, but they're referred by someone who's an active listener. So, the people that listen, progressive, thoughtful people are kind of into this thing. They're likely better able than most to take care of their own things, but they become an influence in their own world. So, these other people reached out based on the influence of listeners. I thought those was pretty cool. I know it's a phenomenon we probably talked about before, and it's something that's happened a lot over the past few years. I think we had three examples last week alone, where people reached out based on a referral from a listener. That was pretty cool.

Ben Felix: That is cool. Maybe like a second-order effect. I don't know if that's the right term for it. But even if we're not speaking directly to potential clients, although we do have people who listen to podcasts, who end up becoming clients as well.

Cameron Passmore: And we have a lot of clients that do listen. So, I just thought I'd share that, so always welcome hearing from new people. Certainly, the advice team wants to talk to new potential clients see if there's a fit.

Ben Felix: Funny question to ask though, why do we do the podcast? We've asked that question before too. It's not an easy question to answer. But I think both of us would say, it's been a great thing to have done and to be doing.

Cameron Passmore: Yeah, but as we said, there's so many unintended consequences.

Ben Felix: That's what I mean.

Cameron Passmore: So many of our people on our team came from wanting to be part of the mission that we talked about. That was not an objective when we started doing this. Six years ago, I think last week, it was six years. Crazy.

Ben Felix: Crazy.

Cameron Passmore: Okay, let's get to the episode.

***

Cameron Passmore: All right, Ben. Let's go. Options, Roaring Kitty.

Ben Felix: I called the topic in my notes, trading options is a loser's game. So, maybe I just gave away the punch line.

Cameron Passmore: I'm pretty sure most people kind of know where this show was going.

Ben Felix: I think it is interesting to look at the data, and there's a bunch of interesting studies on this, specifically looking at retail investors trading in the options market. As I mentioned in the introduction, Roaring Kitty reappeared recently. In his reappearance, which he did through a meme, posted on his Twitter account of a guy sitting back in his chair and then moving forward and the chair. It's like pay attention, I think, is what the image was suggesting. So, that happened, and then there's a big jump in the price of GameStop. In the meantime, Keith Gill had built some positions that he later posted online.

Anyway, interesting story. He may have made some enormous profits. I haven't followed it super closely, but that kind of gives this glimmer of hope for retail investors who may dream of getting exceptionally wealthy by trading options. Unfortunately, well, that story is incredible, truly. Most retail investors are unlikely to replicate Roaring Kitty's success. It gets really tricky, because I can say that, and our podcast listeners can hear me say that and they can even listen. But there's research on this. The conspicuous success of any trader will tend to entice the people watching them. And someone like Roaring Kitty, who has a huge audience, there are a lot of people watching, that's a challenge.

Then, the other thing that I think is tricky here is there's a lot of money to be made by the financial institutions that are facilitating retail options trading. So, I can sit here and say, "You know, this is a bad idea, don't do it." But people are going to be compelled when they see successful outcomes. And there are a lot of financial service providers that are more than willing to facilitate this activity. And in many cases, even promote it through the way that their apps are structured and things like that. The end result for retail investors is pretty ugly.

Options, just a very quick background. Options are financial contracts that give the option holder the right but not the obligation to buy or sell a set quantity or dollar value of an asset at a fixed price by a set date. They're super useful tools for many reasons. They've arguably revolutionized not only finance. but everything. We talked to Robert Merton about that, back in his episode about just the impact of mathematical models on financial markets, and on the economy, on everything. Probably a super important innovation, almost certainly a super important innovation. But well, they can be used for good, like some of the stuff that I just mentioned. Some of their features, a big one being embedded leverage make them a bit of a double-edged sword. They can just as easily be used for risk management, and hedging, as they can be used for speculation, and gambling.

Now, one of the things happened, coincident with Roaring Kitty, and the GameStop phenomenon, and COVID, those things are all highly likely somehow related. Over that time period over the last few years, retail options trading has exploded in volume. Commission-free trading is another big one. Yes, Robin Hood. In Canada, we've got Wealthsimple trade. They're all these platforms that make it really easy for people to trade options. There's been this really interesting social and technological phenomenon where it's become a thing, where retail investors can easily trade options.

One of the papers that I looked at, which is a fairly recent one in the Journal of Finance, it found that over one period, and relatively recent history, retail trading made up more than 60% of the total offence market volume.

Cameron Passmore: Wow.

Ben Felix: It's crazy, right? It's hard to look at Roaring Kitty as the example we keep coming back to, and not imagine what that would be like to generate the kind of wealth that he has through trading. There's an experimental research paper on this that actually suggests that's roughly what happens. When someone gets exposed to the results of successful traders, they end up increasing their own risk-taking. Then, there's another paper that looks at investors engage in copy trading, so that's people who are following the trades of other users, and online social investing platforms. Those people following, other people, they tend to prefer riskier high volatility stocks, and they trade more, but they actually end up with more negative returns. So, it's not working out very well for them. This idea of being shown the successful outcomes of other traders seems to make people invest in trade more aggressively, themselves, which I think makes sense. Social anchoring of trading outcomes.

Cameron Passmore: Depending on the profile of that person, I guess. Is it typically younger, typically male, as you talked about in the past, you think?

Ben Felix: I don't know if I saw data on that in these papers. There's a paper from Juhani Linnainmaa, who is a past Rational Reminder guest. It's a 2003 paper, though, so I didn't add it to my notes. But it did find in a finished sample that traders tend to be, I think it was like 30-year-old males with relatively high incomes. For these papers, looking at options trading, I don't think that I had demographic data. I wouldn't be surprised if it is similar.

I mentioned earlier that the trading platforms, they really don't help with us. They promote options trading. I mean, I get ads on Reddit all the time for one of the Canadian trading firms, self-directed firms promoting their options platform. They make trading options seem like it's this easy, and really good experience, and a smart thing to do. At least that's what I infer from the ads that I get. If I didn't know any better, I'd probably think I should be trading options.

The reality is, here's the punch line. Trading options has not been great for retail investors. Most retail investors take significant losses on their options trades larger than the losses they take from equity trading, which is interesting and makes sense, I guess, because of the leverage. A lot of the negative outcome is due to overreacting the past stock market returns, and then another big piece of it is high trading costs. One paper suggests that the motivations to trade options seem to largely be gambling, speculation, and entertainment, which is also interesting. It's not a hedging motive, that's another way to say that. Another interesting thing related, I think, to the way that the options are being used is that the retail traders often prefer options with very short maturities, primarily calls, and they have huge bid-ask spreads. This one paper, this is the one in the Journal of Finance. They find, over 12% average bid-ask spread for the option that the retail investors and their sampler are trading.

Cameron Passmore: Why would you think calls would be more popular?

Ben Felix: I don't know. Do you have an idea?

Cameron Passmore: I'm trying to think that through. There'd be a reason why.

Ben Felix: I don't know. Maybe one of the papers looked at it, and didn't dig into that though. So, those wide bid-ask spreads that effectively makes trading options super expensive. For retail investors, you're paying this massive implicit trading cost every time that you place a trade. But it also makes it very lucrative for the financial institutions that are executing retail order flow.

Another interesting point is that, retail investors seem to be attracted to trading options around announcements with high-expected volatility, likely because these are events that get a lot of media coverage. It's well known from other research that investors have limited attention, rather than rationally evaluating the full opportunity set of things that they could invest in, they often focus on attention-grabbing securities. That could be, in this case, options on a stock with a lot of media coverage around the upcoming announcement. So, that ends up driving investor demand for those options around announcements, announcements with high-expected announcement volatility, and that contributes further to poor realize returns on those trades.

In that same paper, it shows investors are slow to close their positions after taking losses, which further exacerbates the negative results. So overall, retail investors in options markets are often overpaying for options relative to realized volatility, due to their focus on attention-grabbing announcements. They're incurring high trading costs due to large bid-ask spreads, and they respond slowly to announcements. In that same study, they estimate that those behaviours translate to losses of 5% to 9% on average, and 10 to 14% for trading around high-expected volatility announcements.

There's another study that looks at the South Korean options market, which is a significant market. They find that retail investors tend to lose substantially, and they quantify it as a percentage of annual household disposable income. So they find that the median retail options investor loses roughly 21% of their annual household disposable income.

Cameron Passmore: Isn't that fascinating?

Ben Felix: Trading options, yes. In that sample, even the top 30% of retail investors lose money in the options market. Not great. That same study, though, and this is interesting, they actually find that institutions who are in the options market are earning positive returns.

Cameron Passmore: So you wonder if the population, the retail investor loses 21% of their annual household disposable income? Do they keep coming back and playing the game? Or do you have to keep finding new people to play the game? And when you go such a heavy weighting of trading done by retail, that 60% number, you wonder if the experiences is bad? Is it the same people to keep coming back to play or is it a new crop of investors?

Ben Felix: I don't have that data, but I do have a paper coming up on why people keep trading despite losing, which is interesting. The explanation there is pretty interesting. In that South Korean sample, the fact that the median retail investor loses, well, the median institution is doing okay. They're using options differently is one piece of it. Then, one thing it made me think of is just the relative complexity of trading options. That could be more challenging for less sophisticated investors. There was actually a paper on that, that confirmed my thinking, I think. It shows it's a 2023 paper, they find that retail trading in complex options become much more common with the advent of commission-free trading.

All of these new commission-free traders tend to prefer strategies with high volatility, high embedded leverage and lottery-like features. Their trades tend to exhibit an optimism bias, but they are negative returns on average. Their losses are increasing with the complexity of the trades. For retail, specifically. That paper kind of suggests that retail investors maybe don't fully understand the risk-return trade-offs in complex options strategies, and that they get lured in by things like leverage and lottery-like payoffs. They may not fully understand what's happening. Maybe there's something there. I think that's an important point, too, is that it's not impossible for a retail investor to use options in a way that is beneficial. It just doesn't seem to be what is happening.

To your earlier question, why do people keep day trading when they tend to lose on average? This one looks at the Brazilian market. They find that traders quit based on the proportion of days with positive profits, but not their total returns. It's really interesting. In this sample, day traders have positive days more often than negative ones, so they keep trading. But their daily returns are highly skewed to the left. Their gains are more frequent, they're making profits more for will make them losses, but their gains are small. They're more frequent, but small. Their losses are less frequent, but much larger. So, they're losing overall in the sample, as with the other samples we've talked about. But their proportion of positive days are greater than the proportion of negative days.

This seems to suggest that day traders in this Brazilian sample, and further own trading skill using the proportion of profitable days, which on its own, is obviously an incomplete and upward-biased measure because of the skewness in positive versus negative returns. That's maybe why.

Cameron Passmore: Hope trumps all. Wow.

Ben Felix: That could be it. Despite these crazy stories like Roaring Kitty, I think trading options has generally been, I would probably call it a disaster for retail investors. They lose money trading options on average, across a bunch of different papers, and their losses are amplified with more complex trades. Retail option trading tends to be speculative in nature, which I think is destructive on its own. But even more so, due to the effect of speculation on option prices around attention-grabbing announcements.

Then, the other big one is the transaction costs. Retail investors are paying these crazy bid-ask spreads to trade options. The other thing is, and I think this is super important with the social media world that we live in, is all of these effects are amplified when investors are showing a successful trader's outcome. I'd love to see the data on all of the retail investors who are following someone like Roaring Kitty, what's their average outcome been.

That was one of the things with the copy trading paper that I looked at is that, people are following somebody who's a successful trader. When they're copying that person's trades will not tend to be successful because of the timing of the trades. This won't be news to any of our listeners, but for most investors, I think building wealth is not something that happens with one big trade, like winning the lottery. It's going to be a long and relatively boring process that consists of saving and investing in a diversified low-cost portfolio. Chasing big wins with trading is more likely to destroy wealth than create it.

Cameron Passmore: Spend less than you make. Diversifying, put time on your side. I think we've mentioned that a few times. Cool. Well for June 27th, this is a nice, tight, clean episode. You want to pop to the after-show now.

Ben Felix: Sure.

Cameron Passmore: A couple of reviews. Kind of kick out of this first one from Gene Fama. Obviously not, but Gene Fama on Apple said, "Ben and Cameron are 11 out of 10, and Mark is mid." Kind of funny that we're reading that one when Mark's not here to defend himself, but –

Ben Felix: It is funny.

Cameron Passmore: We know it's a joke. Do you want to read the next one?

Ben Felix: Sure. Garrett HD from Canada says, "Worth every minute. After finding the show not too long ago, I went back to the start and binge every episode available and have now listened to every single one. That takes a lot of time and as the show reinforces both time and energy are immensely valuable, yet I feel this investment was greater than any five-factor tilt portfolio, or large-cap, high-dividend yielding Bitcoin tech stock."

Cameron Passmore: Wow.

Ben Felix: "The show brings rationality as promised, but also discusses where rationality may not be optimal. The interviews with guests are some of the best out there. The deep dives are informative and evidence-based, taking a ton of research, and the after-show has been a gift for all three of us. Thank you, all of you, including those who work behind the scenes for helping the lives of so many for all you do." Very nice.

Cameron Passmore: So, we've got a handwritten letter, holding it up here, from Patty in the UK. I think it's worth reading. It's not a very long letter. "I'm quite sure you get many emails, letters." We haven't got many letters, maybe a handful. "Notes and tweets thanking you for the amazing work that you and Mr. Felix put into the world on the Rational Reminder Podcast. However, I wanted to write and tell you the positive impact it's had on me in the hope that you never underestimate how much you folks are helping people all over the world. My name is Patty, I'm 25, and I'm not a financial professional. My day job is as a young officer in Britain's Royal Navy. This says interesting financial implications as all young officers are on the same pay scale, and we all get the same. So, you know that the only difference in wealth between us is behavioural. Listening to all the research about financial decision-making, happiness, and the hedonic treadmill that you've researched has helped me avoid the classic first paycheck BMW on finance trap, which many of my colleagues fall into. Number two, our pensions or non-contributory, defined benefit schemes, which means I can take much more risk on my private pension due to the annuity-like provision in my government one. Something I figured out after listening to Wade Pfau and Moshe Milevsky. But more important than anything, purely financial to me, the podcast has allowed me to start my financial planning exams in the UK, which they do online, one module at a time when I can get around to it around work. I never would have done that without the knowledge base that the podcast gave me. Secondly, and most importantly, it allows me to help my family, my father's pension was in high-fee active funds, which have been able to convince him to change due to the overwhelming evidence of their poor performance on aggregate. Additionally, I've been able to teach my sister about saving and investing, and what the various tax-advantaged and tax-deferred accounts mean for her. Apologies for the rather long-winded letter, but it's so important that you know how much you are helping people! Thank you to the whole RR team, and for all the interviews, book reviews, discussions, and debates. Yours faithfully, from Patty.

Ben Felix: Very nice.

Cameron Passmore: Very nice. And to take the time to write a letter, that's very nice and pretty much appreciated. Any news from the community you want to share?

Ben Felix: I don't think so. It's been pretty active.

Cameron Passmore: Something I wanted to put out there. I spoke to Dan this morning, actually. As we mentioned, Mark is helping do the Canadian version of Dan's most recent book, Wealthier. This Dan Solin, our friend, and two-time, three-time guest. The book should be ready for launch in September, and Dan is going to be in Ottawa in late September, early October timeframe. Hopefully, Mark will also be in town, and we can do some RR meetup, book launch. We're not sure what it's going to be. If you're going to be in the area and you're interested, just drop us an email, we'll make sure to keep you on a list. We will notify people with more details later on. But the sooner we can start building a list, the better. So, you can reach out to info@rationalreminder.ca. It'd be super fun to do something. Might even do it in Montreal too. We'll see how much flexibility everybody has.

Ben Felix: Nice.

Cameron Passmore: That'd be nice to see that book come out, which would be great. Upcoming guests, these may not be household names. But boy, these are incredible conversations coming up. This are people kind of on the nerdier side of things. We have John Griffin next week, and Valentin Haddad in three weeks. I don't know if you want to add in some background of those or not.

Ben Felix: They're going to be episodes that everyone's going to want to listen to. Lots of really, really good topics, really great research from both of them. Last week was another, I think great research with Antionette Schoar, another good episode.

Cameron Passmore: Lot of good content coming. How was your week? Reasonably had a week off.

Ben Felix: Yes, it was good. Went on a road trip, hang out. It's nice.

Cameron Passmore: Biggest takeaway.

Ben Felix: I don't know. I like being outside. But I already knew that. Spent a lot of time outside.

Cameron Passmore: Goes back to that thing of awe, and you're near the ocean too, right?

Ben Felix: Yes, near the ocean. Spent a day in Quebec City.

Cameron Passmore: Oh, you head to the old town, obviously, I assume.

Ben Felix: Yes.

Cameron Passmore: First time for your kids being there.

Ben Felix: Yes. Saw the fortifications, went to the waterfall near Quebec City. This really tall waterfall with a really cool hike up to the top of it.

Cameron Passmore: That's nice. Is that the Montmorency Falls.

Ben Felix: Yes.

Cameron Passmore: Very nice. I haven't been there in a long time. I used to go quite often, because I grew up a couple hours away, but not far from there. So, this episode gets released on Thursday, the 27th. So, tomorrow, the 28th, Lisa's last day working. She retires tomorrow.

Ben Felix: Oh, wow. That's exciting.

Cameron Passmore: Can you imagine, like to have a front-row seat to someone actually coming to the end of a incredible 31-year career as a teacher, then as a vice principal. So, 28, that whatever time she finishes, it's end of that career, which is pretty amazing.

Ben Felix: Wow. That is amazing.

Cameron Passmore: Anything else on your mind with what I think might be our shortest episode ever?

Ben Felix: I think it is our shortest episode ever.

Cameron Passmore: But that's okay. It's June 27th, that's all right.

Ben Felix: That's true. We've talked about just not doing episodes in the summer. So, I mean, maybe this is better than that. I don't know.

Cameron Passmore: We're recording this in a sweltering heatwave in Ottawa. It's like 35 degrees here right now.

Ben Felix: Yeah, it is smoking hot.

Cameron Passmore: Any final thoughts or you're good to go?

Ben Felix: I don't have anything else. That's it.

Cameron Passmore: All right. Be good to have Mark back in a couple of weeks. Next time we're here, be after Canada Day, Independence Day, and be right in the thick of summer. So all right. As always, everybody, thanks for listening.

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