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r/WallStreetBets: The Future of Day Trading?


Six months ago, the share price of GameStop (GME) was $4.15. A month ago, it had risen to $17.25. By mid-January, the rally gathered speed, touching $145 on the 26th, a dizzying $483 on the 28th, before crashing down again. As of close of 2nd February, the share price of GME had retreated to $90.

In the meantime, trading was suspended on most retail brokerages, and most of the finance community became obsessed with this hitherto obscure stock.

What on earth was going on?

To students of economic theory, these valuations would appear insane – and indeed, to any reasonable onlooker, one would have to agree. On a simple level: the inherent value of a company is unlikely to double in the space of a day, let alone increase 116-fold over the course of six months.

GME was not the only company to see this volatility: AMC Entertainment saw its share price increase from $2.18 on the 14th January to a staggering $20.36

The story is a little more complex than simple market irrationality. There are a number of different stories at play here: a technical story, about how options markets operate; an emotional story, about herd behaviour; and a network story, about how platforms such as Reddit have encouraged decentralised decision making.

What even is r/WallStreetBets?

Long story short, WallStreetBets is a Subreddit (a forum within Reddit) where typically day traders discuss their potential plays. As of the 3rd of February, this forum had over 8 million members.

Some commentators noticed management changes taking place within GME – the addition of Reggie Fils-Aimé to the Board, and the famous Michael Burry’s long position in the company – and started proposing a bull case for the company. Before long, GME became the most discussed company on the Subreddit, with day traders piling in.

Surely that couldn’t have been enough though?

Correct. Fundamental reasons – that is, those relating to the underlying strength of the company – only tell part of the story here. There are two additional technical aspects to note.

First, GME was a heavily bet against company – by the New Year, over 100 per cent of the available GME stocks were “shorted”, mainly by hedge funds. This is where a hedge fund will borrow a stock, sell it, and then buy back the share later at a cheaper cost, pocketing the difference.

However, if the share price of that company rises, then hedge funds can be forced into “covering” their bet, where they have to buy the stock to hedge their losses. This will drive the share price further up.

The more heavily shorted a stock, the more likely that this “short squeeze” can happen if the share price starts rising for a particular reason.

Secondly, r/WallStreetBets is known for overly aggressive day trading – more similar to gambling in nature. In particular, it is known for the use of option trading. These speculators would buy an option for GME, that is, the right to buy the stock at a certain price, significantly above market price.

The sellers of those options would then hedge their losses by buying some of those shares in the case that it does go up. Hence, as with the “short squeeze,” pushing the share price further up.

Who won and who lost?

Well, the clear losers are the hedge funds that were betting against GME. Melvin Capital, one of the main hedge funds shorting GME, faced a 53% loss in their assets ($4.5 billion), even after a $2.75 billion cash injection from Point72 Asset Management and Citadel.

As for the day traders? It probably depends when they got in and when they got out. There will surely be many a day trader who made millions trading options, before subsequently losing it all again.

What’s new here then?

Broadly speaking: the financial markets have never had to deal with the rise of bored day-traders with stimulus cheques and zero-commission trading.

Platforms such as Trading212 in the UK and Robinhood in the US have allowed ordinary punters the ability to use complex financial instruments in novel and unanticipated ways – and in unprecedented volumes.

On January 27th for instance, a record 24 billion shares traded hands, and 27 million option contracts were exchanged – and the most popular stocks were WallStreetBets favourites: GameStop, Blackberry and Nokia.

Image: EPIC

But is it market manipulation?

“Pump and dump” schemes, where someone buys cheap stocks, lies about their value to get others to buy, before selling themselves, are rightfully illegal.

However, what r/WallStreetBets did is slightly different: they didn’t lie. They simply pointed out that if everyone bought into GME, then there would be a short squeeze and everyone would make money (apart from the hedge funds).

However, this might still make it illegal: the Securities Exchange Act of 1934 makes it illegal “to induce the purchase or sale of any security” by claiming that the price “is likely to rise or fall because of market operations”.

That is to say, as the FT puts it, “you are not allowed to pump up stocks simply for the sake of pumping them”. Whether or not this counts as “inducement” or not is unclear – but the spirit of the legislation is clear, that these games are to be avoided.

It is unlikely that we will see much action taken, however. The decentralised and anonymous nature of these forums – as well as the sheer number of participants – make it very unlikely that any regulator will be able to crack down upon this sort of market coordination.

r/WallStreetBets is here to stay.

How are hedge funds reacting?

Like it or not, the advance of the day traders is here to stay: the introduction of zero-commission of trading, and the introduction of complex financial instruments into the hands of relative amateurs is a process that other market makers will have to react to.

And, indeed, hedge funds are already doing so: it will be crucial for market players to be aware of where retail interest might suddenly emerge, and to protect themselves from that.

Quiver Quantitative, an alternative data provider, scrapes information from r/WallStreetBets, using language analysis to determine sentiment within the forum. In recent weeks they have identified a surge of interest from hedge funds seeking real-time information about how day traders are thinking.

Is this an anti-capitalist revolution?

Some have sought to compare this to the Occupy Wall Street protests – and although they might point to the desire amongst new players to make one or two particular hedge funds go bankrupt – this seems overplayed.

The FT accurately points out that “market-makers, prop desks and high frequency traders are pretty happy about record volumes of share trading,” while the day traders themselves were, on the most basic level, seeking to make a profit off market speculation. It’s hardly anti-capitalist.

Moreover, the rising share prices for the firms affected has caused them to take advantage of their new situation. In the last week, AMC Entertainment has been able to raise an additional $304.8m through selling shares directly onto the stock exchange through its broker.

They could use this to help trim its debt pile of $5.5 billion or help stave off the cash burn the company has been experiencing recently. Alternatively, the high share price could attract some debt-for-equity swaps, reducing its debt burden further.

But what about Robinhood preventing trading – is that illegal?

This is where it gets slightly complex. We’re going to need to go quite in depth to explain how trades actually settle.

When you trade shares on Robinhood – or indeed, on any platform, those transactions do not settle immediately. In fact, it typically takes two days to do so. However, this requires the broker (Robinhood) to put forward capital guarantees to ensure that the clearing house (for example DriveWealth) has sufficient funds throughout the settlement process.

Throughout the settlement process, the shares area is actually held by the Depository Trust Company (DTC). The DTC is essentially the central storage of shares in the US, processing and settling all transactions.

However, the increase in volatility meant that the DTC has an enforced increase in capital requirements of 250% on companies wishing to trade shares.

In short: in order for Robinhood to process transactions, it needs to stump up cash, fast. And to its credit, it has. In the last four days, it has raised $3.4 billion – this cash has enabled Robinhood to restart trading in shares to meet the demands of its clearing houses.

And while there has been an emergence in class-action lawsuits amongst disgruntled traders, Robinhood, and other such brokerages, are not legally bound to carry out every trade, with the user agreement saying that Robinhood “may at any time, in its sole discretion and without any prior notice to Me, prohibit or restrict My ability to trade securities”.

So, what’s the last word?

Reddit may not be as classy as the Financial Times. But there might increasingly come a time where sentiment in its decentralised forums might have more of an effect on the stock market than a leader article in the FT. Technically illegal or not, r/WallStreetBets is here to stay.

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