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Robinhood, Reddit, Gamestop, and You | 2X Wealth Group to the Sophisticated Goliaths Who Were Short These Stocks

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Robinhood, Reddit, Gamestop, and You | 2X Wealth Group to the Sophisticated Goliaths Who Were Short These Stocks February 3, 2020 | 2X Wealth Group With a combined 50+ years of experience, Robinhood, Reddit, GameStop, 2X Wealth Group is committed to educating and You and empowering investors. We firmly believe financial The Making of a Financial Flash Mob literacy helps people make better decisions. Who doesn’t love the story of David’s triumph over Goliath? This past week a group of “small” investors made tremendous amounts of money (on paper at least) by buying stocks that were heavily shorted by large, sophisticated hedge funds. We explore what happened, factors that spurred the market disruption, the subsequent fallout still unfolding, and finally, what it all means going forward. What Happened? First, it’s important to understand three concepts - short selling, call options, and a short squeeze. If an investor wants to profit from a stock declining in value, they can short the stock. Most understand the concept of buying stock, but shorting is more complicated. Shorting involves selling a stock that you don’t own. So, how do you sell something that you don’t own? The answer is - you borrow the stock through your brokerage firm, and you must put up money to do so. The broker requires that you maintain a balance large enough to repurchase the borrowed stock at any time. Therein lies the risk. If you buy a stock, the most you can lose is the amount you paid. In other words, the value of your investment can only go to zero. If you short a stock, however, there is no limit to the amount you can lose. If forced to close the position, you must buy back the stock you sold regardless of its price. Regulators, aware of the limitless loss potential, have more stringent rules and requirements for short sellers which relate to both net worth and the experience of the investor. As a result, it is rare to see individual investors short stocks. In the story of last week, the Goliaths (hedge funds) were short a number of stocks (GameStop, BlackBerry, AMC and Bed Bath and Beyond to name a few) where they thought the companies’ business models were flawed and their stocks would decline significantly. Enter David (not just one, but a bunch of ‘Davids’) who used a Reddit message board called WallStreetBets to encourage other Davids to join them in buying the stocks of these heavily shorted companies. David, with relatively small amounts of money, caused a great deal of pain Robinhood, Reddit, GameStop, and You | 2X Wealth Group to the sophisticated Goliaths who were short these stocks. The Davids were able to create big price moves with small amounts of cash not only because of their sheer number, but also through the use of call options (a way to gain leveraged exposure to a stock). The Goliaths may have been rich and sophisticated, but they were vulnerable, and a few of those Davids figured out how to exploit them. The Davids concentrated buying created a “short squeeze”, making the short positions held by the Goliaths more and more expensive to maintain. To understand the magnitude of this disruption, take GME, for example. The stock closed out 2020 at $18.85 a share and at the high last week, traded at $483, an increase of 2500%. At first, the Goliaths were able to maintain their short positions by raising capital from outside investors and/or selling other stocks they owned. But when the Davids (and copycats including some professionals no doubt) were undeterred, at least several Goliaths capitulated and reluctantly bought back their short positions, locking in sizable losses. Even Goliath doesn’t have limitless capital. The fans cheered. David (the little guy) had defeated Goliath (the big bad hedge funds). A 'Perfect Storm' Set the Stage A confluence of factors led to the market spectacle last week. We name several of the important ones below. Robinhood Robinhood and other online trading platforms perpetuated easy and cheap access to trading. Commissions were eliminated. Robinhood clients could trade from their phone and their requirements with regard to both net worth and investor experience (including option trading) were less stringent than at other brokers. These changes led to increased retail trading activity, which rose from 15% to 20% of total trades in the past year. Further, retail options trading volumes currently exceed those of institutions. Changes in SEC Rules Over the last several years, the SEC has attempted to level the playing field for all investors regarding company information, disclosure rules and access to short positioning data. This access to information provided kindling for the fire. Social Boredom With reduced ability to bet on sports or go to casinos, gamblers increasingly traded options. In this way, the recent disruption was similar to the Dutch tulip bubble of 1636 – explained by some as “no more than a meaningless winter drinking game, played by a plague-ridden population that made use of a vibrant tulip market.” Social Media Social media financial sites have exploded, with WallStreetBets growing to 2 million followers during the pandemic and increasing to 6 million as the short squeeze played out. The power of social media aided and abetted the Davids. Populist Resentment Toward Wall Street After the Financial Crisis After the Financial Crisis, many Reddit posts reference how people were hurt when the financial crisis hit and were furious that Wall Street had no consequences. There are references to 'getting' the hedge funds and acting as a group to accomplish a goal. Some see the current situation as an online continuation of the Occupy Wall Street movement. Call Option Feedback Loop Although not a new financial instrument, call options options (contracts to purchase shares at an agreed upon price per share) are a leveraged way to take advantage of a rising stock BP020521 Robinhood, Reddit, GameStop, and You | 2X Wealth Group price. Rather than buying the shares outright, the purchase of call options allowed the Davids to control a large amount of stock with a much smaller initial outlay of cash. The high volume of call option purchases pushed stock prices even higher, as market makers who sold the call options were required to buy more of the underlying stock to satisfy regulatory requirements. This process promoted a vicious upward cycle in price. Easy Money Conditions A recent piece in the Washington post, by Maureen O'Hara, mentions two historical examples of ‘easy money’ creating problems. “The Swedish economist Knut Wicksell, in an observation that resonates today, argued in 1898 that bubbles are attributable to interest rates that are too low. In 1929 — we know what happened in the markets then — the Dutch economist historian, N.W. Posthumus, cited the entrance of nonprofessional buyers fueled by credit. In this view, today’s Federal Reserve and the Reddit crowd would seem natural culprits.” In other words, extremely low interest rates make risk taking more attractive. The Fallout Robinhood restricted trading in the heavily traded stocks and needed to raise capital. It is no surprise that Robinhood had to raise capital. Total trading last Wednesday was higher than in any other market disruption in the past 20 years, including the dot com bust and the failure of Lehman Brothers during the financial crisis. The SEC rules require brokers to maintain a certain amount of capital as a ratio of outstanding trades to ensure timely settlement.. Given the inordinate volume of trading last week, Robinhood was concerned they might breach those net capital requirements unless they slowed trading and raised more capital. Chief executive Vlad Tenev said a clearinghouse requested ‘around $3 billion’. Hedge funds, such as Melvin Capital, lost over 50%. Hedge fund losses created turmoil not only in the heavily shorted stocks but also in other stock prices as the funds may have been forced to sell winners to shore up capital. Some investors (big and small) took advantage of the windfall. There are reports of people paying off student loans and home mortgages with gains from these stocks, and according to Bloomberg, a teachers’ retirement fund was able to sell one of their losing positions for $500 million. The remaining holders of inflated stock are likely to lose money. The value of a stock is only worth as much as someone else is willing to pay for it. Although the stock prices of these heavily shorted stocks have gone up, their business models remain flawed. As the short squeezes abate, one would expect the prices of these companies to go back to reflecting their economic value. Some individual investors could have substantial losses and lose their newfound enthusiasm for participating in the stock market. What does all of this mean? The public may view shorting stocks as an aggressive trading practice. Shorting offers an important function, however, by providing an efficient allocation of capital in shifting money away from poor business models to more productive ones. Nothing is truly free. Politicians and uninformed investors may have believed that Robinhood was helping the ‘have nots’, but in fact Robinhood has been in bed with the ‘haves’ from the beginning. Robinhood didn’t charge investors commissions, but they were making millions of dollars selling order flow to market makers such as Citadel Securities, giving these institutions the legal opportunity to get BP020521 Robinhood, Reddit, GameStop, and You | 2X Wealth Group in front of the retail client trades. Many think this process affected the quality of trade execution by effectively allowing a legal version of frontrunning. As the adage goes, if you arenot paying for the product you are the product. Will brokerage firms, market makers and hedge funds change the way they do business? Contact Us: • Possible regulatory changes include increasing restrictions on options trading and increasing margin requirements on positions.
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