Last week, you could not turn on the news without hearing about the market mania. How a Reddit forum almost put a hedge fund out of business, the little guys vs the big guys. There has been a lot of misconception about what happened and hopefully I can clarify it for you.
The website where this viral story started was Reddit. It’s a social news platform where users can discuss and vote on content. Almost any subject matter can be found and discussed on Reddit: stocks, shopping, sports, tech, etc.
The Reddit forum, called WallStreetBets, made news when they decided to promote and buy the same few stocks. WallStreetBets is notorious for posting extremely risky and speculative bets on the market but this time the users worked together and bought the same few stocks.
One trader who goes by “RoaringKitty”, had roughly $46 million and a 4,000% gain (WSJ 1). The forum now has over 7 million subscribers, or as they call it “degenerates” and combined probably have some serious money.
A hedge fund was short one of these stocks (betting the price would go down). When the price shot up drastically, they had to get out of their short position. When you buy a stock the most you can lose is the money you put in. But when you short you can lose more than you put in because the price can continue to go up.
The short position hurt this hedge fund and according to the Wall Street Journal, they lost 53% in January. They needed a $2.75 billion-dollar investment from Citadel and Point72 to stay afloat.
Now what? Reddit traders use terms like “diamond hands 💎✋” or “hold the line” which means to hold a stock even when it goes down in value. A lot of these traders use Robinhood to buy/sell stocks and that caused even more problems when they restricted trading.
Robinhood
Robinhood is a broker-dealer who facilitates trades of stocks, bonds, crypto and more. All broker dealers (LPL Financial, Fidelity, ETrade, etc.) must follow the same rules and regulations.
When Robinhood customers buy and sell stocks those trades do not settle right away (T+2). Meaning Robinhood is responsible for having cash on hand so users can continue to trade during the settlement period. Last week, Robinhood didn’t have enough cash on hand to meet the clearinghouse requirements.
Rules on deposits for certain stocks were raised by the clearinghouse because of the extreme volatility (GameStop, AMC Theatres and more). Robinhood didn’t have enough money on hand to cover their deposit requirements which is why they restricted trading in certain stocks and raised $3.4 billion from investors. Unlike Robinhood, our broker dealer LPL Financial, was not restricting orders and business continued as usual.
In my opinion, Robinhood created this mess on their platform by encouraging risky behavior. I’ve used Robinhood in the past and they make it extremely easy to buy and sell stocks, which leads to people over trading. Their platform updates prices constantly and sends numerous notifications. It’s also extremely easy to trade options and use speculative investments strategies. Which is a quick way to lose money if you don’t know what you’re doing. By encouraging risky behavior, Robinhood had a higher percent of their users who owned these risky stocks and that resulted in restrictions on stock trading.
For Robinhood, it would make sense that they encourage trading because they sell their order flow. Firms like Citadel buy their order flow and had a record year in revenue from trading operations (Bloomberg 4). 29% of GameStop’s trading volume (from 1/25-1/28) was handled by Citadel Securities, according to this WSJ article.
As much as this started as a feel-good story of the big vs little guys, these large firms will continue to make lots of money. A couple hedge funds lost money, but the majority of Wall Street is making money from this. For example, Silver Lake sold $713 million of AMC stock after this Reddit fueled rally (Reuters 5). They capitalized on these inflated prices and sold it to people who have no idea what they’re doing. These people are now “holding the bag”.
Contact me:
Email: george@pmgwealth.com
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Phone: (847) 550-6100
Definitions
Holding the bag: is used to describe an investor who holds a position that decreases in value until it becomes worthless.
Hold the line: Hold the stock even if it goes down in value
Diamond hands: if you have diamond hands, you are in theory ready to hold a position for the end goal, despite the potential risk
T+2: Trade date plus two days. For most stock trades. Settlement occurs two business days after the day the order executes.
Short Position: profiting when the stock price declines
Sources/ Disclaimers:
1. Roaring Kitty Wanted to Break a 4-Minute Mile. He Broke Wall Street Instead
2. Melvin Capital Lost 53% in January, Hurt by GameStop and Other Bets
3. Robinhood Raises Another $2.4 Billion From Shareholders ($3.4 total)
4. Citadel Securities Reaps Record $6.7 Billion on Volatility
5. Silver Lake cashes out on AMC for $713 million after Reddit-fueled rally
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy ensures success or protects against loss.
