Episode 311 - Is Roaring Kitty a Good Role Model?

0:03This 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. Welcome to episode 311. The third person, Mark, who's normally here, is actually on vacation this week. We're 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? You want to jump right into the topic? No, I want you to cue the topic up and then we'll jump in after.

0:42Oh, sorry. You're rusty. Sorry. Yes, people, Ben is rusty. 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 there'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, wow, look at all the money he made with his trades. Maybe I can do that too. We're going to talk a little bit about the data around that.

1:23Cool. 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 podcast, they're probably not necessarily ideal prospects or clients for us. And while 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 a variety of reasons saying they needed help with some planning or some investment item, but they were referred by someone who's an active listener.

2:06So 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 that was pretty cool. I know it's a phenomenon we've probably talked about before and it's something that's happened a lot over the past few years. But I think we had three examples last week alone where people reached out based on a referral from a listener. So that was pretty cool. That is cool. So that may be like a second order effect.

2:36I 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 the podcast who end up becoming clients as well. 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. And certainly the advice team loves to talk to new potential clients, see if there's a fit. 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.

3:07Yeah. But as we've said, there's so many unintended consequences. That's what I mean. So many of our people on our team came from wanting to be part of the mission that we talk about. That was not an objective when we started doing this. Six years ago, I think last week. It was six years. Crazy. Crazy. Okay, let's get to the episode.

3:31All right, Ben, let's go. Options, Roaring Kitty. I called the topic in my notes, trading options is a loser's game. Maybe I just gave away the punchline. I'm pretty sure most people know where this show is going. I think it is interesting to 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. And 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 in the chair.

4:08It'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. And in the meantime, Keith Hill 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 gives this glimmer of hope for retail investors who may dream of getting exceptionally wealthy by trading options. Unfortunately, while 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.

4:54The conspicuous success of any trader will tend to entice the people watching them. Someone like Roaring Kitty, who has a huge audience, there are a lot of people watching, that's a challenge. 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, 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.

5:31So the end result for retail investors is pretty ugly. Options, just as a very quick background, are 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. And 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 and on everything. Probably a super important innovation, almost certainly a super important innovation.

6:07But while 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 that's happened, And 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. Oh, and commission-free trading is another big one.

6:47You got Robinhood and Platinum. In Canada, we've got WealthsimpleTrade. There are 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 in relatively recent history, retail trading made up more than 60 % of the total options market volume. Wow. 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.

7:28There'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 engaged in copy trading. That's people who are following the trades of other users in 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. 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 and trade more aggressively themselves, which I think makes sense.

8:09Social anchoring of trading outcomes. Depending on the profile of that person, I guess, is it typically younger, typically male, as you've talked about in the past, do you think? I don't know if I saw data on that. In these papers, there's a paper from Ioani Linema, who was a past rash reminder guest. It was 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.

8:43I mentioned earlier that the trading platforms, they really don't help with this. They promote options trading. 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 punchline, 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.

9:30A lot of the negative outcome is due to overreacting to 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 is 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 a over 12 % average bid-ask spread for the options that the retail investors and their sample are trading.

10:12Why would you think calls would be more popular? I don't know. Do you have an idea? I'm trying to think that through if there'd be a reason why. I don't know. Maybe one of the papers looked at it. I didn't dig into that though. 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.

10:50It'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 an 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 realized returns on those trades. In that same paper, it shows that investors are slow to close their positions after taking losses, which further exacerbates the negative results.

11:27So 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 behaviors 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.

12:11They find that the median retail options investor loses roughly 21 % of their annual household disposable income. Isn't that fascinating? Trading options, yeah. 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. 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?

12:45When you've got such a heavy weighting of trading done by retail, that 60 % number, you wonder if the experience is this bad, is it the same people that keep coming back to play or is it new crop of investors? 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 while 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.

13:27There was actually a paper on that that confirmed my thinking, I think. It shows in the 2023 paper, they find that retail trading in complex options has become much more common with the advent of commission-free trading. All of these new commission-free traders tend to prefer strategy 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 suggests that retail investors maybe don't fully understand the risk return trade-offs in complex option strategies, and that they get lured in by things like leverage and lottery-like payoffs.

14:15They 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.

14:53They keep trading, but their daily returns are highly skewed to the left. Their gains are more frequent. They're making profits more frequently than losses, but their gains are small. They're more frequent, but small. Their losses are less frequent, but much larger. They're losing overall in this 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 infer their 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.

15:33That's maybe why. Hope trumps all. Wow. Yeah, it 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.

16:12Retail 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 that 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 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.

16:47This 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. Spend less than you make, diversify, and 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? Sure. A couple of reviews.

17:25Got a 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 and Mark's not here to defend himself, but it's a joke. I don't know. You want to read the next one? Sure. Garrett HD from Canada says, worth every minute. After finding this show not too long ago, I went back to the start and binged every episode available and have now listened to every single one. That takes a lot of time. And as this show reinforces, both time and energy are immensely valuable. Yet I feel this investment was greater than any five-factor tilt portfolio or a large cap high dividend yielding Bitcoin tech stock.

18:07Wow. 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. So we've got a handwritten letter holding it up here from Patty in the UK. And I think it's worth reading. It's not a very long letter. I'm quite sure you get many emails, letters.

18:41We haven't got many letters, maybe a handful. Notes and tweets thanking you for the amazing work that you, Mr. Felix, put into the world on the Rational Monitor 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 Patti. I'm 25 and I'm not a financial professional. My day job is as a young officer in Britain's Royal Navy. This has 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 behavioral.

19:17Listening to all the research about financial decision-making, happiness, and the hedonic treadmill that you researched has helped me avoid the classic first paycheck BMW on finance trap, which many of my colleagues fall into. Number two, our pensions are 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 Moza Malefsky. But more important than anything purely financial to me, the podcast has allowed me to start my financial planning exams in the UK, which I do online, one module at a time when I can get around to it around work.

19:57I never would have done that without the knowledge base that the podcast gave me. Secondly, and most importantly, is allow me to help my family. My father's pension was in high fee active funds, which I've 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! So thank you to the whole RR team and for all the interviews, book reviews, discussions, and debates.

20:37Yours faithfully from Patty. Very nice. Very nice. And to take the time to write a letter, it's very nice and very much appreciated. Any news from the community you want to share? I don't think so. It's been pretty active. Something I wanted to put out there, I spoke to Dan this morning actually. So as we've mentioned, Mark is helping do the Canadian version of Dan's most recent book, Wealthier. This is Dan Solon, our friend and two-time, three-time guest. So the book should be ready for launch in September and Dan is going to be in Ottawa in late September, early October timeframe. And hopefully Mark will also be in town that we can do some sort of RR meetup book launch.

21:19We'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 at rationalreminder.ca. Be super fun to do something. Might even do it in Montreal too. We'll see how much flexibility everybody has. Nice. It'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. We see where people kind of on the nerdier side of things.

21:55We 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. 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 Antoinette Shore. Another good episode. A lot of good content coming. So how was your week? Recently had a week off. It was good. Went on a road trip, hung out. It was nice. Biggest takeaway? I don't know. I like being outside, but I already knew that. Spent a lot of time outside.

22:32Goes back to that thing of awe. And you're near the ocean too, right? Yep. Near the ocean. Spent a day in Quebec City. Oh, did you get to the old town? Obviously, I assume. Yep. First time for your kids being there? Yep. 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. Oh, that's nice. Is that the Momorense Falls? Yep. Very nice. I haven't been there in a long time. 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.

23:09Lisa's last day working. She retires tomorrow. Oh, wow. That's exciting. Can you imagine to have a front row seat to someone actually coming to the end of an incredible 31-year career as a teacher, then as a vice principal? So at 28th, whatever time she finishes, it's end of that career, which is pretty amazing. Wow. That is amazing. Anything else on your mind with what I think might be our shortest episode ever? I think it is our shortest episode ever. But that's okay. It's June 27th. That's all right. That's true. We've talked about just not doing episodes in the summer. So I mean, maybe this is better than that.

23:42I don't know. We're recording this in a sweltering heat wave in Ottawa. It's like 35 degrees here right now. Yeah, it is smoking hot. Any final thoughts? Are you good to go? I don't have anything else. That's it. All right. Be good to have Mark back in a couple of weeks. Next time we're here, be after Canada Day and Independence Day and be right in the thick of summer. So, all right. As always, everybody, thanks for listening.

24:08Thank you.