Most U.S. equity index derivatives settle “a.m.” on the 3rd Friday of each month via the constituent stocks’ opening trade price. We show that U.S. equity prices drift upwards from Thursday close to 3rd Friday open and revert immediately after derivative payoffs are calculated. Thus, equity futures and call option payoffs are biased upwards, while put option payoffs are biased downwards. We estimate a wealth transfer of $4 billion per year in SPX options alone. These findings are consistent with channels relating to inventory management by option market makers or market manipulation by sophisticated investors. Both explanations rely on the existence of an illiquid trading period that precedes option settlement and, indeed, we show that the payoff bias emerged only after the advent of overnight equity trading in the early 2000s. We argue that current settlement design is inefficient and propose that the a.m. settled derivative time be moved away from the illiquid overnight period.

The recent surge in retail option trading has sparked concerns about gambling and significant losses. We show that these concerns may be exaggerated using a novel trader-level dataset of about $20 billion in retail stock and option trades between 2020 and 2022. Option trades account for nearly half of all trades in 2022, making them a vital part of retail trading. Moreover, many investors trade only options. Despite wide bid-ask spreads, retail option trades incur relatively small losses. Although options theoretically resemble lottery tickets, we find little evidence of positive skewness in realized dollar profits, contradicting gambling-driven trading. A typical retail trade is the purchase of a one-day S&P 500 index call held for an hour. Finally, retail investors tend to trade options to affordably participate in high-priced underlyings and to obtain leverage. Overall, we offer the first thorough trader-level analysis of current retail option trading.

Delta-hedged returns and straddles, used in studies on option return predictability, are found, on average, to be negative. We find that both the sign and size of these returns arise from the period around the expiration Friday. Risk of assignment and option rolling activity on expiration days drive this effect. This creates a large and robust monthly cyclical pattern in option prices. Using monthly returns and accounting for rolling activity around expiration makes the predictive ability of a large number of option and stock characteristics for options returns weak and insignificant. Our results hold importance for a broad class of studies on options market efficiency.