New research reveals high option trading fees and barriers to competition
Could the rules of the options market be quietly costing you ten times more than your stock trades? A new study in The Review of Financial Studies, “Payment for Order Flow and Option Internalization,” uncovers how current market rules protect high profits for option wholesalers and create significant financial incentives for brokers to favor option trading over stocks. Authors Thomas Ernst of the University of Maryland and Chester Spatt of Carnegie Mellon University’s Tepper School of Business highlight that while recent regulatory focus centers on the stock market, the more complex and lucrative options market remains largely unaddressed.
The research finds that routing option orders generate substantially higher payment for order flow for brokers than routing stock orders. Currently, an average retail option trade earns a broker approximately 40 cents per 100 shares, which is double the 20 cents earned for a comparable stock trade. When considering typical investment amounts, a dollar invested in options can generate 10 times as much revenue for a broker as an investment in equities. This discrepancy creates a potential conflict of interest, as brokers may face financial pressure to encourage clients toward more frequent or complex option trading.
The study also identifies a significant barrier to entry in the option wholesaling industry. In the option market, designated market makers (DMM) hold a unique advantage by obtaining the first five contracts of any order they bring to an exchange. This rule allows dominant firms to trade against retail orders without needing to offer the best price on the public market. Currently, just two firms, Citadel and Susquehanna control 60 percent of these DMM positions and purchase over 70 percent of all retail option order flow.
These structural advantages protect wholesaler profits but often result in higher costs for individual investors. While price-improvement auctions exist to give investors better deals, wholesalers often use these auctions selectively or benefit from rules that discourage other participants from bidding.
The findings come at a time of massive growth in retail option trading. The authors suggest that expanding data disclosure requirements and reducing certain exchange fees could help lower costs for retail clients. By shedding light on these market structures, the study provides a roadmap for regulators to ensure fairer competition and better outcomes for everyday investors.
Journal
Review of Financial Studies
Article Title
Payment for Order Flow and Option Internalization
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