Retail trading and social media
A few years ago I worked for a retail financial trading company. Like many others, I noticed how most retail traders lose money. Retail trading is basically ‘dumb money’.
That's why I was very surprised when I heard the news about r/WallStreetBets retail traders inflicting losses on Melvin Capital. My reaction was "no way! Retail traders don’t have that kind of firing power! Who's the ‘big whale’ trader hiding behind r/WallStreetBets?"
So, I started exploring the r/WallStreetBets story and I discovered a fascinating world.
The origins of WallStreetBets
This Bloomberg article traces the origins and evolution of r/WallStreetBets and retail traders' attack on short sellers. Short sellers are those traders who speculate on the decline of an asset price.
22 months ago a user known as delaneydi argued that GameStop's shares were undervalued. The view fell on deaf ears, but then two things happened.
First, Scion Capital's Michael Burry said he had a long position on GameStop shares. Read Gregory Zuckerman's The Greatest Trade Ever (2009) and Michael Lewis' The Big Short (2010) if you want to know who Burry is.
Second, an idea emerged about GameStop falling so low ($50 cents) that it would only cost about $45 million for the retail crowd to buy up the entire float. At this point retail traders thought that they could gang up to invest in a single security. This was around mid-August 2019.
In April 2020, a r/WallStreetUser called Hedgehog implored GameStop investors to call their brokers and start a war against short-sellers.
On 31 August 2020, Ryan Cohen, co-founder of Chewy Inc., disclosed a 5.8 million-share stake in GameStop and that announcement became the tipping point in favour of investors going long on GameStop against short sellers.
Shares began to rise steadily in the last four months of 2020, as more and more retail traders joined the bandwagon. Memes were used extensively to organize the campaign—hence, the name ‘meme stock’ to refer to shares of companies which are highly volatile and popular among retail traders on social media.
At this point, r/WallStreetBets began to attack major short sellers such as Gabe Plotkin of Melvin Capital and Andrew Left of Citron Research.
Robinhood app, zero-commission trading and options
Still, the story didn’t make full sense to me because I couldn’t understand where retail traders got their firepower to buy GameStop shares.
That’s when we should focus on Robinhood trading platform for retail investors. Robinhood lets investors buy and sell stock, but above all it allows them to easily buy options instead of the stock itself.
In other words, if you think that the share price of GameStop will go up, you can buy for a small premium a call option that lets you buy 100 shares of GameStop at a specific strike price on a specific date. Having exposure to 100 share for a small premium is a form of leverage. Too often leverage leads to disaster—and, sadly, also tragedies among retail traders.
The broker selling you the call option has to hedge that trade by buying the actual stock. That makes the share price go up, and the more it goes up, the more shares the broker has to buy. This amplifying process is called gamma squeeze. It is described very well in this episode of Odd Lots podcast.
Before Robinhood and similar retail trading platforms, the option market has never been within reach of retail investors. This phenomenon is unprecedented, although retail investors were attracted to options already during the 1920s. Back then, options were sold in a small over-the-counter market.
Why is so cheap to buy options today?
It is cheap to buy options because Robinhood engages in ‘payment for order flow’ with big investment management firms like Citadel and Virtu Financial. Order flow from retail investors are directed to Citadel, which takes the other side of the order, flips the trade, and pockets the difference between bid and ask spread. See this FT article to know more about this practice.
Interestingly, sending customers’ orders to electronic trading firms such as Citadel and Virtu means that these firms would typically deal with small investors’ orders privately instead of routing them to public markets. In other words, payment for order flow shifts a large portion of equity trading to dark pools.
What now?
The WallStreetBets revolution has died down. However, the combination of digital technology (e.g. Robinhood platform), cheap options (thanks to the payment for order flow practice), and social media-induced herd behaviour is a long-term phenomenon that is likely to stay.
Asset managers are improving their understanding of social media sentiment as a key alternative data in investment strategies.
Retail traders will continue to depict their action as a revolution against mainstream financial organizations. Popular participation in US financial markets is not a new phenomenon. It is at the core of American capitalism. See Konings’ book on the development of US finance, this article by Hochfelder on the late-1800s bucket shops, and this fantastic article by MacKenzie and Pardo-Guerra on the 1990s electronic communication network known as Island ECN. On herd behaviour and crowd phenomena in financial markets, see the amazing work by Kristian Bondo Hansen.
Regulators will need to think long and hard about how to deal with this new world of retail trading.
At the same time, Robinhood and other retail trading platforms will need to deal with capital rules and collateral posting better, instead of restricting customers from buying more shares when the platform is running low on funds to post as collateral. If they really want to democratize finance, then restricting customers from buying more shares doesn’t look too democratic.
Crucially, Robinhood and other retail trading platforms should emphasise the value of long-term investing instead of short-term speculation.