Could the way the options market is set up be quietly costing you far more than your stock trades? A recent study published in The Review of Financial Studies suggests that it might. The paper, titled “Payment for Order Flow and Option Internalization,” looks at how current rules in the options market allow certain firms to earn high profits while creating incentives that may not always favour everyday investors. While regulators have paid close attention to stock trading in recent years, this research argues that the more complex options market has received far less scrutiny.

One of the key findings is that brokers earn much more money from options trades than from stock trades. When a broker sends an options order to a trading firm, they receive what is called “payment for order flow.” On average, a retail options trade brings in about 40 cents per 100 shares for the broker, compared with roughly 20 cents for a similar stock trade. When you look at it another way, each dollar invested in options can generate up to ten times more revenue for a broker than a dollar invested in stocks. This creates a situation where brokers may have a financial reason to steer clients towards options trading.

This difference in earnings raises concerns about potential conflicts of interest. If brokers make significantly more from options, they may be more likely to encourage frequent or more complex options trades, even if those trades are not necessarily in the best interest of the investor. For individuals who may not fully understand the risks of options trading, this could lead to higher costs and potentially poorer financial outcomes over time.

The study also points to barriers that make it difficult for new firms to compete in the options market. A key rule gives certain firms, known as designated market makers (DMMs), the right to handle the first portion of trades they bring to an exchange. This gives them a built-in advantage, as they can trade against incoming orders without always offering the most competitive price available in the wider market. As a result, a small number of firms dominate this space.

In fact, the research shows that just two major firms control a large share of the market. Together, they hold about 60 per cent of these designated positions and handle more than 70 per cent of retail options trading orders. This level of concentration means there is less competition, which can keep costs higher for investors. Although there are systems in place, such as auctions designed to improve prices, these are not always used in ways that benefit retail traders.

All of this is happening at a time when options trading has become increasingly popular among individual investors. The authors suggest that better transparency and changes to certain market rules could help reduce costs and improve fairness. For example, requiring more detailed data reporting and adjusting exchange fees could make it easier for new competitors to enter the market. By highlighting these issues, the study offers important insights for regulators aiming to create a more balanced and investor-friendly trading environment.

More information: Thomas Ernst et al, Payment for Order Flow and Option Internalization, Review of Financial Studies. DOI: 10.1093/rfs/hhaf108

Journal information: Review of Financial Studies Provided by Carnegie Mellon University