How Robinhood and Reddit Have Changed Options Trading -- and How You Can Profit

It's true retail investors have become much more active options traders in recent years, but they're not the only ones who determine which stocks end up soaring.
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Unless you’ve been living under a rock, you know retail traders have been joining the markets in droves.

In 2010, they made up just 10% of all daily stock trades, and an even smaller percentage of daily option trades. Today, retail traders make up as much as 25% of the market.

Think about that for a second. One out of 4 traders is a retail trader. If you would have told me that 10 years ago, I would have laughed.

But do you know what caused this retail boom? Or how you can profit from it by tracking the trends of retail traders and market makers? I do, and I’m going to break down both for you today.

The Retail Trader Boom

There are three main factors that have caused the retail trader boom:

The first is something you might be using to read this article right now -- your cell phone. With apps like those from Robinhood, TD/Schwab and E-Trade, you can trade on your phone from work, in an airport terminal, on the train or just sitting down on the couch while waiting to beat your friend in a game of Fortnite.

The second factor is somewhat directly related to Robinhood; Robinhood was the first broker to offer commission-free trading.

With commission-free trading, there’s no barrier to getting in and out of stock and option positions. This has caused trading in both stocks and options to explode in the last year. Options trading, in particular, has exploded to levels we’ve never seen.

Read More: The Worst Options Trade You Can Make

In Dec. 2019, the Options Clearing Corporation cleared 227 million option contracts. That may sound like a lot, but between the 20 trading days in December that works out to about 11 million option contracts per day on average.

In Feb. 2021, that number almost tripled to 572 million, or over 30 million contracts PER DAY. That’s a 3X increase in daily option trading volume in 13 months!

This is because traders perceive that there is no cost to getting in and out of their stock and option contracts (there IS a cost from the bid-ask spread traders pay, but that cost is far more opaque to the average trader).

The final factor that has caused retail traders to jump into options is the pandemic.

Don’t have a lot to do? Just got a ‘stimmy?’ Stuck on the couch at your parent’s place playing video games, or trying to scrape by doing work on Fiverr?

Read More: The Most Common Mistakes New and Old Options Traders Make

Why not put that stimmy in a Robinhood account and try to create some money for yourself in names like TSLA or PLUG or FCEL? Why look for work on Fiverr when you can make more trading options on FVRR?

But $1,200 does not go far to buy a stock, does it? If you really want to make money trading a small account, you need to use leverage; you need to trade options.

The increased option volume I talked about above is from retail traders buying cheap options (because they have a small account) trying to make money on “you only live once” (YOLO) trades.

How It All Plays Out

Let’s take a look at an example. NIO Inc.  (NIO) - Get Report is the “Tesla of China.”

Take a look at this chart.

NIO Options

Twelve different strike prices, 185,000+ contracts...ALL EXPIRING IN three days.

This would be rare on any company, much less a Chinese electric car company. Experienced traders look at this and think: “What the heck?”

Read More: How to Get Started Trading Options

It’s true, options with short expirations tend to be the cheapest, so they can be more attractive. When a stock does move, these options cause wild swings because they are so close to their expiration date.

Ten years ago -- heck, ten months ago -- I would NEVER have seen this kind of heavy option interest just three days before an expiration date. NEVER.

But with an influx of retail traders “making bets” using options that mostly expire worthless, this heavy option traffic has become the new normal.

And when these trades do hit it big, BOY do they hit it big, and it creates a crazy amount of “fear of missing out” (FOMO), which can exaggerate stock moves.

Read More: What Is Options Trading?

What Happened With AMC

Take AMC  (AMC) - Get Report, for example. Just as GameStop blew up, AMC caught its coattails.

On Jan. 26, the stock closed at $4.96. Options volume was over 330,000 option call contracts… ALL expiring in three days.

When the stock started blowing higher the next day, market makers had to cover their original position taking the other side of the retail traders’ trades, causing the stock to catapult EVEN higher.

The result? AMC closes at just under $20 -- one day later.

Now, if you are wondering how these new retail traders magically pile into the same 10 stocks at once, there are two reasons:

Reason One is that the brokers (especially Robinhood) publish to their clients what their other clients are buying. This creates name FOMO and also causes a Robinhood feedback loop in option and stock volume.

So a stock pops → It hits the Robinhood Top 100 stocks → More retail traders buy it

And so on and so forth...

Volume begets volume, and with the brokers telling their traders what everyone else is buying, it causes volumes to just go up and up and up.

Reason Two is that social media, TikTok and Reddit are driving volumes in specific names. I’ll talk about Reddit in a second, but let’s start with TikTok.

Some of the most ridiculous messages get posted by people who CLEARLY know nothing about financial markets and are just trying to get people to pay for their ideas, ideas which currently seem to be "what is trending on Robinhood…buy that."

Reddit is a bit of a different animal. The WallStreetBets community on Reddit is a lot more like a trading pit than many in the professional community would probably like to admit. These traders are sharing ideas, and trading as a group. Back in the day on the floor, it was not THAT different.

That said, as powerful as the posters on Wall StreetBets are, they probably need to know that their forums are being spammed with bots, and more importantly, read by artificial intelligence.

This allows market makers and hedge funds to deploy algorithms on Reddit boards that resemble those Facebook ads stalking you about your abandoned Nike cart from last week (“How did they KNOW I wanted those Air Jordans!?!”).

These algorithms scrape public forums to find the stocks that are receiving heavy traffic and positive publicity -- and market makers and hedge funds use that information to make money off of retail traders.

Wall Street Takes It to Wall Street

Over the summer, my firm OptionPit.com ran a test on the performance of Robinhood stocks that were rising in the Top 100 ranks. Stocks that were moving higher quickly actually had HORRIBLE returns.

We then overlaid a system that tracks institutional block trading. We found that when retail traders buy -- and then institutional money moves in afterward -- THOSE are the stocks that really go to the moon.

The key to this tracking system is observing the size of the trades being executed in a name. As the trade size goes up, that is a clear indication that large houses are moving into a name and that it is going to go up. You should be able to get this data from your broker.

Looking back at AMC, do you think the retail public ALONE bought 330,000 calls in a single day on AMC?

No way!

A HUGE portion of that was Wall Street, market makers and hedge funds buying along with Redditors.

I know everyone thinks Reddit took it to Wall Street when GME blew higher -- and they kind of did. WallStreetBets certainly started the process, but in the end it was the market makers’ and hedge funds’ data-scraping algos that really caused the stock to explode…

Essentially, Wall Street took it to Wall Street.

The lesson is this -- there are reasons that volumes are exploding, but trying to trade off FOMO alone is not going to make you money. Trading with impact money, like the big banks that are trading WITH the YOLO names...now that is how you can really clean up.

Mark Sebastian provides options analysis and trade ideas each day on Real Money Pro, TheStreet’s premium service for active traders. Click here to learn more and get great columns, market commentary and actionable trade ideas from Mark Sebastian, Paul Price, Doug Kass and many others.

Disclosure: At the time of publication, Sebastian had no positions in any security mentioned in this article.