In defense of Robinhood
Video game retailer GameStop (ticker: GME) made national headlines after its stock soared from a price of $17.25 on January 4, 2021, to an intraday high of $483 on January 28, 2021—a 2800% gain. Some fortunate speculators, most notably a 34-year-old Boston man named Keith Gill, profited immensely from this rise. Others bought in too late to the hype and experienced significant losses—on Thursday, February 4, the stock ended the trading day at $53.50, an 88.9% drop from the January 28 high. In this post, I would like to discuss my view on why this happened, as well as some of the other views I've seen on the Internet and why I think some are a little unjustified.
For disclosure, I have an account at Robinhood, but I have not done any trading on GameStop's stock (or any other meme stock).
Background
Short selling
When most people invest in the stock market, they buy shares of a particular company's stock, hoping that later on, they will be able to sell their shares to someone else for a higher price. In other words, they are hoping that the stock price will go up. This is technically called holding a long position on the stock.
Advanced traders are able to carry out market strategies that are more complicated than simply buying shares of a stock. It is possible for traders to borrow shares from their broker and then sell those shares in the market for an immediate gain, hoping that later on they will be able to buy back those shares and return them to their broker for a lower price than what they initially sold them for. In other words, they are hoping that the stock price will go down. This is called short selling a stock or holding a short position on the stock.
Holding a short position on a stock is considerably riskier than holding a long position a stock.
- Your maximum risk on a long position is the amount of money you paid to open the position.
- Suppose you bought 100 shares of GameStop for $17.25 per share.
- The most amount of money you could possibly lose is $1725, which is the amount of money that you paid to buy those 100 shares (excluding any commissions or fees).
- You would only lose this much if the stock price went all the way to $0 (perhaps the company went bankrupt and ceased to exist).
- Your maximum risk on a short position is theoretically unlimited. This is because there is theoretically no limit to how high a stock's price can rise.
- Suppose you borrowed 100 shares of GameStop from your broker and then immediately sold them to the market for $17.25 per share.
- If the stock rises to $40, then in order to close your short position, you will need to buy 100 shares of GameStop at $40 per share, resulting in an overall loss of $2275. (Your account received an immediate credit of $1725 when you opened your short position, and now your account is being debited $4000 to buy the 100 shares of GameStop to close the position: $1725 − $4000 = −$2275.)
- This would be quite unfortunate because the maximum possible gain on this investment is only $1725 (which only happens if the stock price went all the way to $0)!
In practice, before you realize unlimited losses, your broker may force you to close your short position for a loss if they think that the position has grown too risky—perhaps the stock price has gone up so much that you would need to use up your entire account balance to buy back the shares.
Options
What options are
I would be remiss if I did not also mention options trading and its role in GameStop's stock price surge. There are two kinds of options contracts:
- A call option is a contract that gives the holder the right, but not the obligation, to buy 100 shares of a particular stock at a particular price on or before a particular expiration day.
- The value of a call option rises as the value of the underlying stock goes up, making owning a call a bullish position.
- Similarly, a put option is a contract that gives the holder the right, but not the obligation, to sell 100 shares of a particular stock at a particular price on or before a particular expiration day.
- The value of a put option rises as the value of the underlying stock goes down, making owning a put a bearish position.
You can buy and sell options on almost any stock just like you can buy or sell shares of those stocks. Most of the time, when a trader buys an option, they are hoping that the price of the contract itself will rise so that later on, they will be able to sell the contract back to the market for a higher price than they paid for it—just like having a long position on a share, only this time it's a long position on an option.
How options are priced
The prices of options (a.k.a. the premiums for the options) are much more volatile than the prices of shares. There are two components to the price of options: intrinsic value and extrinsic value.
- Intrinsic value is the amount of money you could make if you decided to exercise your option.
- For example, suppose you buy a call option on Apple (ticker: AAPL) with a strike price of $100 with an expiration date of March 19, 2021.
- This means that anytime between now and March 19, 2021, you may choose to exercise this contract, which would cause you to buy 100 shares of AAPL for a price of $100 per share instead of whatever the current market price is.
- At the time I am writing this, AAPL was last trading at $136.76 per share. If you wanted to buy 100 shares of AAPL at the normal market price, you would have to pay $13,676. However, if you exercise your call option, you can instead obtain 100 shares for only $10,000. You could then immediately sell those 100 shares back to the market for $13,676, giving you a net profit of $3,676, or $36.76 per share.[1] This $36.76 per share is known as the intrinsic value of the call option.
- If a call option's strike price is above the current market price of the underlying stock, then the contract has no intrinsic value. This is called being out of the money. Likewise, a call option whose strike price is below the current market price does have intrinsic value and is considered in the money.
- Extrinsic value is whatever value the option has after subtracting the intrinsic value.
- Extrinsic value is generally made up of two components: time value and implied volatility.
- In general, the more time an options contract has until its expiration date, the more expensive it will be to buy that contract. This added value is part of the extrinsic value.
- An options contract will also be more expensive if there is increased demand for the option because traders believe that the stock price will move a considerable amount and make the option trade profitable. This is called implied volatility.[2]
- Options that are out of the money only have extrinsic value because there is no intrinsic value. Although you cannot exercise an out-of-the-money contract for any intrinsic value right now, the contract is still worth something because there is a chance that the contract will become in the money at some point before the contract's expiration date—and there is a greater likelihood of that happening the farther out we are from expiration and the higher the implied volatility.
For an example, at the time I am writing this, the premium for a $100-strike AAPL call option expiring March 19, 2021, is $37.10 per share that the contract controls. Because the contract controls 100 shares, we would need to pay $3710 in order to buy this call option. As I calculated above, because the current share price of AAPL is $136.76, the intrinsic value of this option is $36.76 per share. The extrinsic value is therefore $37.10 − $36.76 = $0.34 per share. As we get closer to March 19, this extrinsic value will increasingly decay towards $0 because of the time value decay. However, the higher the underlying stock price rises, the more intrinsic value the option will collect. Essentially, buying this call will give you the leverage to control 100 shares of Apple's stock for just $3710, instead of the $13,676 needed to actually buy 100 shares.
I've tried to give a broad overview of what options are in this post, but there is clearly a lot more to it. Personally, I think the best YouTube video that explains the basics of options trading is this one by the YouTube channel InTheMoney. Check it out if you would like to know more about options trading.
Gambling with options and WallStreetBets
On Reddit, there is a subreddit called WallStreetBets, or WSB for short. There, a bunch of amateur traders gather to treat the stock market like a casino. Speculative WSB traders will frequently throw their entire account balance at risk for the chance to make a life-changing profit.
One of the most common tactics employed by WallStreetBets involves buying a call option that is out of the money and expiring very soon. For example, if AAPL is currently trading at $134.92 (which it is as I am writing this), then a WSB user might buy a call option with a strike price of $150 expiring next month. Because the option is out of the money, the premium for the option would be rather inexpensive. The effect of the trade is that there is a high likelihood that the trader loses their entire investment—if on the option's expiration day AAPL is trading below $150, the option will expire worthless (why would you want the right to buy 100 shares of AAPL at $150, when you could simply buy 100 shares of AAPL at the current market price?).
However, in the unlikely event that AAPL does end up above $150 on the expiration day, then there is the opportunity for massive returns on investment. Remember, for every $0.01 above the strike price AAPL is on expiration day, that is $1 of instrinsic value that the call option now collects (because you can exercise the option to buy 100 shares of AAPL at $150 per share and then immediately sell those 100 shares at whatever the current market price is). If, for example, you initially paid $134 for the call option (which is actually the current price of the $150 AAPL call option expiring March 19, 2021, at the time I am writing this), then for every cent that AAPL finishes above $151.34, you can collect one dollar of profit (the break-even point is $151.34 in order to make back what you initially paid for the contract). Suppose AAPL does extremely well and closes at $160 on expiration day—then the intrinsic value of the option will be $1000 (because you could exercise the option to buy 100 shares at $150 per share and then immediately sell all those 100 shares for $160 per share; there is no extrinsic value at expiration). This would be an incredible gain because, remember, you only paid $134 for the call option to begin with. That means you've made $866 net profit, or a 646% return on investment off of an 18.6% movement in the underlying stock.
Now imagine instead of just $134 to buy one contract, you put your entire account balance of, say, $13,400 into buying 100 contracts—your account balance would now be $100,000 (an $86,600 gain). It would be an idiotic trade because there is a high probability of losing all $13,400 (which would happen if AAPL closes at $150 or less on expiration day), but if you get lucky, you could make a lot of money. People on WallStreetBets actually do this, and frequently the most upvoted posts on the forum are screenshots of either massive gains or massive losses.
What happened
Short squeeze
What happened with GameStop's stock in January 2021 is known as a short squeeze.
I like to think of it as a sort of reverse crash. Whenever a stock
"crashes" in the traditional sense, typically it involves a lot of
investors selling their shares of a particular stock because they see
its price is rapidly falling, and this panic drives the price down even
further. In a short squeeze, investors who hold short positions on a
stock may be forced to buy to close their short positions because they
see the stock's price is rapidly rising, and this drives the price up
even higher, causing even more short sellers to have to buy more shares
to close their positions. It is a positive feedback loop.
Apparently, there was extremely high "short interest" in GameStop stock in January 2021, meaning an inordinate number of investors—mainly hedge funds managed by large investment firms like Melvin Capital—held short positions on the stock. Remember, when you open a short position, you are selling borrowed shares to someone else in the market; the person who bought those shares from you can then lend them to someone else, creating another short position involving the exact same shares. Because of this, it is actually possible to have more than 100% short interest on a particular company's "float" (the number of shares that are available for trading), and that is reportedly what happened with GameStop. According to S3 Partners, a firm that describes itself as a "data power company", in January 2021, as much as 140% of GameStop's float were part of short positions (see the graph on this Wall Street Journal article).
GameStop
was not the only stock affected by the short squeeze, but it was by far
the most spectacular. Other companies involved included, but were not
limited to, AMC (the movie theater company; ticker: AMC) and BlackBerry
(the obsolete smartphone company; ticker: BB).
Gamma squeeze
In addition to the "short squeeze" that I discuss above, there is another kind of "squeeze" that happened in January with respect to GameStop has to do with options trading. Whenever you buy an option, someone in the market has to sell one to you. There are entities out there known as "market makers" that make up the bulk of most options trades. These are trading firms in charge of providing "liquidity" in the market. In the case of GameStop, WSB users bought a ton of out-of-the-money call options on GameStop's stock, and for the overwhelming majority of these users, a market maker sold them those options—essentially, the market markers have short positions on those call options.
In order to limit their risk, market makers will "hedge" their positions by buying shares of the underlying stock (in this case, buying GME stock). Buying shares allows market makers to limit the amount they lose from selling a call option in the event that the stock price goes up: basically, as the stock price goes up, the value of their short position on the call option goes down, whereas the value of their shares of the underlying stock goes up, balancing each other out.
There's a catch, however. Each call option has a statistic associated with it called the delta, which describes how much the value of that option will increase as value of the underlying stock increases. This delta determines how many shares market makers need to buy to hedge their short positions on the call options. Out-of-the-money options tend to have a small delta. For example, as I am writing this, the $160 AAPL call expiring March 19 has a delta of 0.0691. This means that for every dollar that AAPL rises, the value of the $160 AAPL 3/19 call will rise $0.0691 per share that the option controls (since it's 100 shares, the total value of the contract will rise by $6.91). Therefore, in order to hedge against this trade, the market maker that sold you this option only needs to buy about 7 shares of AAPL—if AAPL rises $1, then then the value of their short position will decrease by $6.91, but the value of their corresponding shares will increase by $7, balancing it out.
That's all well and good, but the catch is that there is yet another statistic called the gamma, which describes how much the delta increases as the value of the underlying stock increases. As the value of the underlying stock rises, so does the delta. For example, the gamma on the aforementioned $160 AAPL 3/19 call is 0.0090. This means that for every dollar that AAPL rises, the delta associated with the call option will rise by 0.0090. So if AAPL rises $1, then the delta on the option will increase to about 0.0781, which means that the market maker will need to buy approximately one more share of AAPL in order to continue balancing out the trade.
As GameStop's stock price surged, the delta on the out-of-the-money call options that WSB users bought also surged because of gamma. This causes the market makers to have to buy more and more shares of the underlying stock in order to hedge against the call options they sold, thereby driving the price up even more. This positive feedback loop is called a gamma squeeze, and this, combined with the simultaneous short squeeze, also contributed to GME's incredible rise in late January.
Trading restrictions by Robinhood and other brokerages
On Thursday, January 28, 2021, the brokerage firm Robinhood decided to restrict trading on GameStop's stock such that users of their platform could only close existing positions. Users could no longer buy more shares or options of the stock, but they could still sell. Robinhood was merely the first brokerage to disallow the opening of new positions; other brokerage firms soon followed, including WeBull, ETrade, and InteractiveBrokers. These decisions immediately affected GameStop's stock price: on Thursday, the stock fell 44% to about $193.60.
After the market closed, Robinhood released a statement on their blog stating that they would begin to allow "limited buys" of the affected securities on the next trading day. According to The Wall Street Journal, Robinhood "fiddled with the limits throughout the day. By the evening, the company had placed restrictions on 51 stocks, limiting users to one share purchase for the majority of them. (For customers whose current positions in those stocks exceed the new limits, Robinhood won’t require them to sell, but also won’t allow them to buy more.)" These restrictions continued in various forms throughout the next week, gradually being eased until they were all lifted on Friday, February 5, 2021, at which point, the price of GME had already depreciated to about $60 per share.
Why it happened
Robinhood's explanation: clearinghouse collateral deposit requirements
Whenever you execute a trade, a record of your trade is sent to an institution called a clearinghouse, which is in charge of making sure that both parties to the trade—the buyer and the seller—actually receive what they ordered. The clearinghouse exists in order to protect against the risk that your counterparty (the buyer if you are the seller and the seller if you are the buyer) is unable to deliver on their side of the trade, perhaps because they are insolvent. This process takes time: currently, it takes two trading days for a trade to "clear" and for the funds and shares associated with the trade to "settle". In other words, although trades appear to be instantaneous when you place them on Robinhood and other brokerages, in reality it takes at least two days for the shares and funds to exchange hands. It only appears instantaneous because during those two settlement days, your brokerage is actually lending you either the money or the shares.
What happens if one party defaults and can't deliver on their side of the trade? That's where your brokerage comes in. Whenever you make a trade, your brokerage firm is required to deposit a certain amount of cash with the clearinghouse as collateral so that if the trade falls through, your counterparty will still receive what they asked for. How much money the brokerage needs to deposit as collateral is determined by the clearinghouse, and it fluctuates based on the volatility of the securities held by your brokerage's customers. The more volatile the stock, the greater the risk that your counterparty will default on fulfilling the obligations of the trade. See also this explanation of the "centeral counterparty clearing" system by the Bank of England.
On Friday, January 29, 2021, Robinhood published a blog post in which it attempted to explain why it had to restrict trading on GameStop and other volatile socks. According to Robinhood, because GameStop's stock price was so volatile during the short squeeze, the Depository Trust & Clearing Corporation, which is Robinhood's clearinghouse, increased Robinhood's usual collateral deposit requirements tenfold, to about $3 billion. As a relatively small startup brokerage firm, Robinhood simply does not have this kind of cash. If they couldn't meet these deposit requirements, then all Robinhood customers would not be able to trade anything until those requirements were met. According to The Wall Street Journal, Robinhood's corporate leadership was alerted to this alarming situation just hours before the start of the trading day, meaning they had just a few hours either to materialize $3 billion out of thin air or restrict trading on the relevant volatile stocks in order to get their clearinghouse to impose smaller deposit requirements.
WallStreetBets' accusations: market manipulation
WallStreetBets was overcome with anger at Robinhood. Countless users said that they would transfer all assets out and close their Robinhood accounts. Almost immediately after Robinhood announced their trading restrictions on GameStop, WallStreetBets began to level accusations of market manipulation and collusion with hedge funds at the brokerage. After GameStop's stock price crashed, many WallStreetBets traders experienced significant losses, and instead of blaming themselves for those losses, they have found a convenient scapegoat in Robinhood. After all, if Robinhood hadn't halted trading on GameStop when it did, it is quite plausible that the momentum of the short squeeze would have pushed the stock price up beyond $500. (One of my friends who traded GME during this time said that he had placed a limit sell order for $969.69, meaning $969.69 was the minimum price he was willing to sell his GME shares for.) To the many retail investors who bought GME shares at the peak, it felt like Robinhood was screwing them over.
In one thread on WallStreetBets on January 28, redditors clamored for a class action lawsuit to be filed against Robinhood. "Allowing people to only sell is the definition of market manipulation," wrote the original poster. "The fucking audacity to call yourself Robin Hood and instead steal from the poor," wrote another user. Another user posted links to the complaint departments at the SEC and FINRA, which are the regulatory agencies responsible for the financial industry, encouraging other users to file a boilerplate complaint against Robinhood. In another thread, one user wrote, "This is absolute collusion with market manipulators and goes against fair market practices. I'm moving on from Robinhood first chance I get. I let previous indiscretions go. But this is absurd." A different user wrote, "So much for being on the side of the little guys like Robinhood 🙄. Just another shill brokerage paid off by the big players. I'll be switching to another brokerage once this is over and I hope everyone here does too."
A key focus of these accusations has revolved around a conspiracy theory that Robinhood imposed these restrictions to benefit Citadel Securities, which is one of the market makers that pays Robinhood for their customer's orders. In addition to being a market maker, Citadel also runs a hedge fund that had shorted GameStop before this crisis and therefore possibly stood to lose a lot of money from the short squeeze. The claim is that Citadel pressured Robinhood to only allow sell orders on GameStop specifically in order to help Citadel avoid further losses on the short squeeze.
These accusations of deliberate market manipulation and collusion with hedge funds are highly improbable. While I do not deny that there exists a perception of a conflict of interest in this situation (see "Valid criticisms of Robinhood" below), Robinhood's explanation of their decision in the context of clearinghouse deposit requirements makes sense. To me, it seems that emotions are running high, and innumerable traders who had large positions on GameStop are understandably upset at the short squeeze's sudden loss of momentum. They are now jumping to conclusions they think are "blatant" based on incomplete and in some cases false information. This is all eerily reminiscent of what we are seeing on social media nowadays with respect to political polarization in the United States; I wrote a blog post on that phenomenon a few months ago.
Valid criticisms of Robinhood
While some of the most extreme criticism of Robinhood may be unjustified, that is not to say that no valid criticism exists. Even some of the most reasoned viewpoints I've read do not completely vindicate Robinhood, and in this section I will discuss what I think were Robinhood's key shortcomings during its crisis.
Poor communication
Firstly, when Robinhood stopped trading on GME and other volatile securities on Thursday, January 29, 2021, they failed to explain clearly why they were doing so to their customers. When Reddit users opened their apps that morning, the only information they had was a message in the user interface: "You can only close out your position in this stock, but you cannot purchase additional shares." Much of the mass confusion, misinformation, and conspiracy theories are the result of Robinhood's failure to communicate clearly on that day.
I remember that when I first learned that Robinhood would be halting trading on GME, my first thought was that Robinhood did so completely voluntarily, that they were trying to protect amateur traders who, in classic WallStreetBets fashion, were throwing their entire life savings—tens if not hundreds of thousands of dollars—at shares of GameStop hoping to get rich quick. This was not in fact the case, but by the time they tried to clarify what actually happened, the damage was done, and rampant misinformation and conspiracy theories had already spread like wildfire.
Even when they did try to clarify what actually happened, they still were not very clear, trying to explain esoteric financial institutions like clearinghouses to their target demographic of amateur investors. The YouTube channel InTheMoney, whose educational video on options trading I linked above, posted a video which highlighted poor communication as the primary leadership failure by Robinhood during the crisis, and I think this is a very reasonable take.
Conflict of interest
Although Robinhood may not have deliberately colluded with Citadel to protect the latter from losses due to the GameStop short squeeze, it is accurate to say that the perception of a conflict of interest exists. That someone has a conflict of interest is not a judgment about their intentions, integrity, or opinions, but rather a mere description of situation.
This was one of the primary points of criticism that a popular finance YouTuber named Andrei Jikh had for Robinhood in this "open letter" video, and I think it's a valid one. Surprisingly, Vlad Tenev, the CEO of Robinhood, actually responded to Jikh. In a video interview uploaded just three days after the open letter, Tenev responded to some of Jikh's questions regarding Robinhood's decision-making process during the GameStop crisis and whether Tenev thinks Robinhood did anything wrong. Tenev correctly highlighted Robinhood's poor communication during the decision to move GameStop to "PCO" (position closing only) as one of the things that Robinhood could have done better.
When Jikh asked Tenev about whether Robinhood may have a conflict of interest with respect to using Citadel Securities as a market maker, Tenev gave an interesting response. It may not be clear to outsiders in the financial industry, but Citadel the hedge fund and Citadel Securities the market maker are actually two separate legal entities, and there are strict regulations regarding information-sharing between the two entities. Citadel Securities the market maker is not supposed to pass information to Citadel the hedge fund regarding Robinhood customer orders. This distinction may be sufficient to resolve the conflict of interest issue from a regulatory standpoint, and it is further evidence against the Robinhood–Citadel conspiracy theory. However, the fact remains that the market maker and the hedge fund share common ownership, and that in itself conveys the perception of a conflict of interest that is responsible for the crippling of Robinhood's public image.
Poor customer service
Robinhood's customer service has long been criticized as inadequate, and today, it remains a valid criticism. To this day, there is no phone number or hotline that you can just call to allow you to speak with a Robinhood customer service representative. Instead, all support requests have to begin via an email that you send through the Robinhood app. We started to see evidence of this inadequacy in March 2020, when Robinhood had to completely halt trading on their platform due to software bugs, which unfortunately coincided with some of the biggest single-day movements in the stock market that year. This all came to a head in June 2020, when a 20-year-old kid named Alexander Kearns committed suicide after incorrectly believing that his account balance was negative $730,000 after making a complicated options trade. There was no number to call, and because the user interface made it look like he now owed Robinhood $730,000, he jumped to false conclusions.
It appears that Robinhood is aware that this has been a common complaint, and according to this CNBC article, over the course of 2020 Robinhood "tripled its customer support team and hired hundreds of registered financial representatives". Additionally, the firm also "said historically, 'it can best serve customers over email' but does reach out to customers via a phone call in certain instances". In September 2020, Robinhood announced that it had updated its user interface to better explain why certain options strategies might temporarily show a large account deficit (like −$730,000), why this is nothing to panic about, and the steps you can take to repair your position.
Even still, some say this is not enough. On Reddit, swarms of users have complained about long wait times for support requests, as well as delayed account transfers. While transferring one brokerage account to another brokerage, it is normal for brokerages to freeze your account while the transfer is taking place, meaning that although you still own your stocks and options on Robinhood, you won't be able to buy or sell them while the account transfer is in progress. This can be stressful if your portfolio contains short-term investments that are exposed to high volatility—if one part of your portfolio takes a huge dip while your account transfer is in progress, you won't be able to repair the position until after your account transfer is complete. To better assist customers in these situations, Robinhood should consider hiring even more customer service agents and also setting up a direct help line that people can call directly to speak with a real human. In February 2021, the parents of Alexander Kearns filed a wrongful death lawsuit against Robinhood. According to Kearns' father, "If he had been able to get a hold of somebody...he would be alive today."
Other brokerages are just better
Finally, if you are considering transferring your assets out of Robinhood and into another brokerage, that may be a smart move, even if you correctly disbelieve the conspiracy theories surrounding Robinhood.
For some traders, Robinhood's feature set may be too limited. You can only trade stocks, ETFs, and options. If you are looking to trade other kinds of securities, like bonds, mutual funds, futures, or forex, you will have to look elsewhere. Additionally, if you are looking to employ complex trading strategies like short selling, place complex limit orders like one-cancels-the-other (OCO) orders, or do frequent day trading with rigorous technical analysis, Robinhood is just not for you. Basically, if you want to become a more advanced trader, other brokerages like TD Ameritrade and Fidelity would probably be a better deal.
The only nice things about Robinhood are its low cost and its clean user interface. Every trade that you make on Robinhood is commission-free (i.e. no fee for making trades), the yearly interest rate for using margin (i.e. borrowing money) is only 2.5%,[3] and the platform also supports fractional shares (e.g. buying 0.25 shares of Amazon for $817.38 instead of a full share for $3269.50). However, even these features are limited in their benefit. Although Robinhood was the first brokerage firm to offer commission-free trading, this business model proved to be so disruptive that in late 2019, numerous other brokerages also decided to do away with commissions—in other words, Robinhood is no longer considered special for having zero commissions. For example, TD Ameritrade also now has commission-free trading for stocks and ETFs. However, its interest rate for margin is 9.5%, and it does charge a flat $0.65 fee per option contract traded. TD Ameritrade also does not support fractional shares, so if you have a small account and you want to invest in a company like Amazon with an expensive share price, you'll have to devote a large percentage of your portfolio value to a single share, which harms your portfolio's diversity.
Finally, we do not really know how solid Robinhood's balance sheet is. Other brokerage firms have been around for decades longer and generally have more customers, money, and experience than a startup firm like Robinhood, so it is less likely that they will become insolvent or otherwise fail to protect their customers if something similar to the GameStop crisis happens again in the future.
What should happen now
Lawsuits
According to The Verge, there are apparently no less than thirty pending lawsuits against Robinhood related to the GameStop fiasco. In my view, these lawsuits have a low probability of success on the merits. If everything Robinhood has communicated about their decision to restrict trading on GameStop is true, then Robinhood acted entirely within their fiduciary responsibility to their customers to restrict trading on GameStop's platform in order to protect their customers from not being able to trade anything, which is what would have happened if they did not restrict trading. It is possible that Robinhood might go for a settlement to avoid heavy legal expenses, but it will be interesting to see whether any of the lawsuits will be successful in court.
Congressional and regulatory investigations
Fully agree. 👇 https://t.co/rW38zfLYGh
— Ted Cruz (@tedcruz) January 28, 2021
Representative Alexandria Ocasio-Cortez (D–NY) and Senator Ted Cruz (R–TX) both tweeted that an investigation should be conducted into Robinhood and the broader GameStop short squeeze. Now, AOC and Ted Cruz ordinarily have diametrically opposite opinions on politics, so to see them both agree that Robinhood should be investigated, that is a pretty compelling sign that Robinhood should probably be investigated. According to this POLITICO article, Vlad Tenev, the CEO and co-founder of Robinhood, is expected to testify before the Financial Services Committee of the U.S. House of Representatives regarding his company's role in the GameStop short squeeze.
As other government entities like the Securities and Exchange Commission (SEC) look into the GameStop saga, I think the most likely outcome will be a simple confirmation of Robinhood's side of the story. That is not to say that Robinhood shouldn't be investigated, but I would be quite surprised if the investigation revealed any deliberate wrongdoing by Robinhood.
Real-time settlement
In a blog post published on Tuesday, February 2, 2021, Vlad Tenev argues that in order to prevent Robinhood's GameStop crisis from happening again, a change needs to occur at the level of financial regulation. Specifically, Tenev advocates for the two-day settlement period for clearinghouses ("T+2") to be replaced by real-time settlement. This solution would prevent a similar situation from happening because Robinhood and other brokerages would no longer be forced to place inordinate sums of money in an inaccessible state for two trading days. According to The Wall Street Journal, such a change does have support by other Wall Street firms, and the head of the Depository Trust & Clearing Corporation signaled that his clearinghouse is "very supportive of shortening the settlement cycle, and to the extent that it’s become a larger topic of conversation in and around the industry, we see that as a net positive".
Increased transparency in the financial industry
In Vlad Tenev's interview with YouTuber Andrei Jikh, Tenev argued that much of the problems of misinformation and confusion surrounding what happened with GameStop stems from a broad lack of understanding by the general public of how the financial industry works. Indeed, before now, not many people knew about or had any reason to care about what a financial clearinghouse was, what "T+2" means, or even what market makers and high-frequency trading firms are. Tenev claims that the primary solution to these issues is to push for more transparency in the
financial industry to educate the general public about how the financial industry works, so that ordinary people can better understand the complex system and why it may lead to certain counterintuitive and perhaps controversial outcomes, like halting trading on GameStop just when it was rising "to the moon", as WallStreetBets traders say. I think more education is a great idea, and I appreciate Tenev's efforts towards achieving this goal, even if they were quite rocky and confusing to start with.
Conclusion
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| As of February 11, 2021, Robinhood is the #2 free app on the iOS App Store. |
In my view, much of the anger at Robinhood is misdirected. WallStreetBets has not convincingly demonstrated that Robinhood acted deliberately to protect hedge funds when they restricted trading on GameStop in late January and early February. Instead, the problem was with the broader system that placed immense pressure on a startup brokerage like Robinhood either to produce billions of dollars it simply did not have or to halt trading on a relatively small number of popular securities. It was a damned-if-you-do, damned-if-you-don't situation. There are valid criticisms of Robinhood in all of this, but halting trading on GameStop in and of itself isn't one of them.
Let's not forget that Robinhood was the brokerage that first introduced the idea of zero-commission trades. Robinhood is the reason why other large brokerage firms like Fidelity and TD Ameritrade also no longer charge commissions, why ordinary people like you and me are now able to participate more actively in the market, no matter what brokerage you use. Robinhood claims that its mission is to "democratize finance for all". While they are far from a perfect company, their remarkable influence on the financial industry over the past decade supports their claim.
Footnotes
[1] I mentioned that after exercising a call option to buy 100 shares of AAPL at $100 per share, you could "immediately" sell those 100 shares back to the market for the current market price of $136.76 per share. This is slightly inaccurate. In reality, it will take at least a day or two for those 100 shares to be delivered to you because behind-the-scenes someone who has a short position on the same call option needs to be assigned to sell you those 100 shares, and that takes time. Instead, while those 100 shares are in movement, you could short-sell 100 shares of AAPL at $136.76 to take advantage of the current market price immediately, and then cover that short position later with the 100 shares you obtain after your call option is finished exercising. Some brokerages, like Robinhood, will immediately lend you 100 shares of the underlying stock as soon as you exercise a call option, so you don't have to worry about this.
[2] The greater the perception that a stock price is likely to change considerably, the greater the implied volatility and thus the more expensive the option. For example, implied volatility is frequently inflated just before a company is about to announce their quarterly earnings. It is generally inadvisable to buy options during this time because after the earnings call occurs, the implied volatility of the option will collapse, decreasing the options' extrinsic value considerably.
[3] In order to trade with margin on Robinhood, you have to have a Robinhood Gold subscription, which is $5 per month, and the interest rate only kicks in for margin used in excess of $1000. See https://robinhood.com/us/en/support/articles/paying-for-robinhood-gold.