In the intricate and rapidly expanding realm of financial markets, a recent investigation published in The Review of Financial Studies has unveiled a largely concealed mechanism within the options trading environment that could be quietly draining money from everyday investors at rates far exceeding those experienced in conventional stock trading. The study, entitled “Payment for Order Flow and Option Internalization,” authored by Thomas Ernst from the University of Maryland and Chester Spatt from Carnegie Mellon University’s Tepper School of Business, provides a technically nuanced and data-rich exploration of how current market structures and regulatory frameworks systematically favor certain market participants—particularly option wholesalers—at the expense of retail traders.
While the spotlight in recent regulatory debates has typically shone on the stock market, the more complex and less transparent options market has remained relatively unexamined. This disparity is particularly critical given the explosive growth in retail options trading, which has fundamentally transformed the trading landscape over the past decade. Ernst and Spatt’s research methodically maps out how brokers—who act as intermediaries between retail investors and the broader market—generate significantly higher revenue through routing options orders rather than stock orders. The average retail options transaction yields approximately 40 cents per 100 shares for a broker, which is notably twice the approximate 20 cents earned on an equivalent stock trade.
This difference in revenue generation is not trivial; it highlights a structural bias with potentially profound implications. In dollar-for-dollar terms, the incentives embedded in today’s market infrastructure mean that brokers can earn up to ten times more from an equivalent investment in options compared to stocks. This asymmetry presents an inherent conflict of interest, where brokers may be incentivized—financially if not explicitly—to encourage clients toward riskier, more frequent, or complex options trades. Such pressures could contribute to misaligned advice and suboptimal trading decisions for investors who may not fully comprehend the cost structures or risks involved.
Delving deeper into market mechanics, the study illustrates how designated market makers (DMMs) in the options market enjoy significant privileges that further entrench their dominant positions. Unlike the stock market, where competition among market makers is relatively dispersed, the options market grants the first five contracts of any order brought to an exchange exclusively to the DMM. This internalization mechanism allows these firms to execute trades against retail orders without necessarily displaying the best price publicly. The practical consequence is a form of preferential treatment that undermines price competition.
Crucially, this concentrated market power is not spread evenly but is held predominantly by two titans of the industry—Citadel and Susquehanna—who control over 60 percent of DMM slots and handle more than 70 percent of retail options order flow. This duopoly not only limits competitive dynamics but also raises questions about market fairness, efficiency, and the real costs imposed on individual investors. By controlling access points and internalizing orders, these firms can maintain elevated profit margins, often at the expense of retail participants.
Adding another layer of complexity, the study highlights the role of price-improvement auctions, which are designed to enhance investor outcomes by allowing multiple market participants to compete to offer better prices. However, the execution of these auctions in the options market is often tilted in favor of wholesalers. They can selectively participate or leverage regulatory nuances that discourage other potential bidders, thereby minimizing genuine price improvement opportunities for retail investors.
This environment effectively creates invisible tolls that erode investor returns. While brokers see increased revenues, the costs are externally borne by ordinary traders who, unaware of the inner workings of these market microstructures, might believe they operate on a level playing field. The current regulatory frameworks have yet to fully address these asymmetries, leaving a blind spot with potentially broad economic consequences.
The timing of this research is prescient given the surge of retail participation in options. Fueled by technology, accessible platforms, and a cultural shift toward active trading, millions of individual investors now engage with options markets daily. However, without changes to transparency, fee structures, and market design, this democratization may paradoxically increase investor vulnerability to hidden costs and conflicts.
Ernst and Spatt propose several reforms to mitigate these issues, centered around enhanced disclosure and adjustments to exchange fee policies. Increasing data transparency could allow regulators, academics, and investors themselves to better understand the true costs embedded in options trading. Lower and more equitable exchange fees might reduce incentives for internalization and promote more competitive bidding, thereby fostering fairer pricing and healthier market dynamics.
In conclusion, this research shines a crucial light on a market segment that, due to its technical complexity and opaque practices, has largely evaded thorough regulatory scrutiny. By quantifying the magnitudes at which brokers profit more from options than stocks and elucidating the structural privileges enjoyed by a few dominant players, Ernst and Spatt’s study serves as a clarion call. It invites policymakers and market participants alike to rethink and reform the underlying architecture of options markets to better safeguard retail investors and promote equitable, transparent, and efficient financial markets.
The findings underscore a fundamental realization: in the evolving landscape of financial markets, sophisticated knowledge is not only an advantage but a necessity. Retail investors stepping into the options space must approach with caution, understanding that the market’s design may inherently favor well-capitalized intermediaries over individual traders. For regulators, the challenge is clear—closing this gap in oversight and leveling the playing field to ensure that innovation and growth in retail options trading translate into broad-based benefits rather than hidden costs.
Subject of Research: Market microstructure of options trading, broker incentives, and regulatory implications in retail options markets.
Article Title: Payment for Order Flow and Option Internalization
News Publication Date: 20-Feb-2026
Web References:
https://doi.org/10.1093/rfs/hhaf108
References:
Ernst, T., & Spatt, C. (2026). Payment for Order Flow and Option Internalization. Review of Financial Studies, DOI: 10.1093/rfs/hhaf108.
Keywords:
Options trading, payment for order flow, market microstructure, designated market makers, retail investors, order internalization, price-improvement auctions, broker incentives, financial regulation, market fairness, Citadel, Susquehanna.
