By now, you have probably heard about the band of guerrilla retail investors who joined the ‘wallstreetbets’ group on Reddit, identified an investment opportunity and then used the platform to crowdfund the execution of what could become potentially the greatest financial ‘David vs Goliath’ take-down in history. The adoption of the now infamous online brokerage app called Robinhood offering free trading with zero minimums, created a perfect technology-enabled storm giving a younger audience the capability to join forces, aggregate their capital and launch a sneak attack on traditional wall street hedge funds that never saw it coming. One of the most fitting memes I have seen characterizing the efforts of the wallstreetbets Redditors likens them to Eddie Murphy and Dan Aykroyd in the classic 1980s comedy, “Trading Places”. But when Robinhood suddenly blocked their own customers from purchasing shares and options of GameStop on Thursday morning just before the market opened for trading, it felt more like the Nobles turning their back on William Wallace in “Braveheart” at the battle of Falkirk. Vladimir Tenev, the CEO of Robinhood, subsequently appeared on multiple news outlets defending their actions, but his inability to explain the company’s reasons in a way that the average person could understand left him and the company looking even more like the traitors the media was painting them to be.
Stock Trading 101
I am by no means an expert on the complexities of how the financial markets work, but I know enough to understand what is happening here on a basic level. If a stock is priced at $12 per share and an investor wants to buy 100 shares, the investor would need $1,200 to make that purchase. If that stock subsequently rises to $20 per share, the same 100 shares could be sold for $2,000 yielding a profit of $800 (minus brokerage fees). Alternatively, if a stock is trading at $20 per share and an investor believes that the price will go down, they can “short” the stock which means they are selling the stock, even though they don’t even own it, in the hopes that they can buy it back later at a lower price (the investor’s broker will have to borrow someone else’s shares to facilitate this transaction). The investor would need to have $2,000 in their trading account to do this because that’s how much it would cost them to buy back the stock at that particular moment. Once the stock goes down to $12 they can buy the stock back for $1200, yielding a profit of $800. The tricky part is that if that stock goes up to $30 instead of down, the investor will have to add an additional $1000 to their account to cover their short position. This is to ensure that if they decide to buy the stock back at $30 per share, they have enough money to do so. If suddenly that stock jumps to $100 per share, the investor is now on the hook for $7,000, making short positions quite risky with virtually unlimited loss potential.
Enter the Hedge Fund
It is common practice for large hedge funds to take very sizable short positions in companies that they feel are doomed to fail. In this case, the company in question is GameStop, a retailer of video games and game consoles which has suffered along with the rest of the retail industry from Covid related declines in revenue. These hedge funds are betting that GameStop’s stock will continue to drop or that the company will go bankrupt leaving the hedge fund with hefty profits after they can buy back the stock for pennies. The information about the “short interest” in a particular company (or amount of shares being borrowed for the purpose shorting the stock) is publicly available. When the group of retail investors in the wallstreetbets Reddit group identified the huge short position that hedge funds had in GameStop, they launched a plan to collectively drive up the stock so high that the hedge funds would have no choice but to buy back the shares at an astronomical price to limit their losses. Given the number of shares that would have to be bought back by the hedge funds, this buying spree would continue send the stock rocketing higher transferring a great amount of wealth from the established old school hedge funds to this group of Redditors that have been labeled in the main stream media as inexperienced, irrational and reckless investors. This is known as a “short squeeze” and the plan was brilliant.
Add the Complexity of Stock Options
Here is the problem. The Redditors were not using cash to purchase shares of GameStop. Instead, they were buying options. Without getting too much into the weeds, this means that they could spend only a fraction of the price of the stock for the option to purchase it later. Based on my understanding, if an individual investor buys an option to purchase a stock, the broker must have a certain amount of funds on deposit to cover that trade. This is because options have an expiration date and depending on the price of the stock when that option expires, the investor may have to fund their account to purchase the stock. If the investor does not have the funds, the broker is potentially on the hook for at least some of those funds.
Now keep in mind that the price of GameStop was trading at $2.57 per share earlier this year, and by collectively buying GameStop options for pennies, the Redditors have been able to push the stock up to a whopping high of $483 per share. Their plan was to continue recruiting more group members and to use Robinhood (and other brokerages) to buy more options, sending the price of the stock so high that the hedge funds would be forced to lose billions of dollars covering their short positions and generating huge gains for the Redditors. But this would force the brokers to have huge sums of money on hand to insure the trades, potentially risking their own financial stability and the potential for a stock market implosion, should these brokers find themselves underwater.
Robinhood’s CEO and the CNN Interview
There are allegations that Robinhood acted in the best interest of large hedge funds that had invested in the company by blocking further purchases of GameStop and only allowing ‘sell’ orders. It remains to be seen if there is any truth to that, but Vladimir Tenev did a terribly job of explaining the financial risk that the Redditors’ activity was creating for Robinhood. During his interview on CNN, Chris Cuomo gave Mr. Tenev the opportunity to show the public that his company, which had built its reputation on ‘democratizing finance’ by working on the side of smaller retail investors, had not in fact stabbed its very own customers in the back to protect its hedge fund investors. But Mr. Tenev’s feeble general statements about having to comply with financial regulations fell far short of a digestible explanation for anyone who is not familiar with how the markets work. Even Mr. Cuomo, who during the interview stated that he has a financial background, was not convinced by Mr. Tenev’s explanation and continued to imply that Robinhood had committed a tragic hypocrisy.
This is a classic case of a CEO lacking the EQ (Emotional Quotient, or Emotional Intelligence) to explain his company’s challenge to the public in a way that the average person could understand. Instead, he either wrongly assumed that the viewers knew enough about the financial regulations to which he was referring, or wrongly assumed that the viewers would simply accept his obligation to abide by certain regulations that forced the company’s actions. He could have taken 5 seconds to say something like “Every time an investor buys an option on a $400 stock Robinhood has to guarantee up to $XX,000 for that purchase, and consider that Robinhood customers were buying on average X options per day.”
Failing on the Brand Promise
Interestingly, many other brokerages implemented the same restrictions on Thursday morning including Webull, Charles Schwab and TD Ameritrade, but they were not criticized with the intensity that Robinhood was. That’s because Robinhood has promoted itself and was successful in creating the image of a company whose mission was to make the financial markets more accessible to unskilled and inexperienced investors. I would argue that it wasn’t the decision to restrict trading that potentially ruined Robinhood’s future, it was the CEO’s fumble of explaining the reasons behind the decision. It was a particularly egregious EQ fail given the alleged inexperience of its novice user base.
Let me be clear that I am not giving Robinhood or the other brokers a pass on this week’s events. Companies (particularly those that have a fiduciary responsibility to protect their customers’ financial interests) should be prepared for unexpected circumstances. The historic volumes of option trades in a handful of stocks promoted by wallstreetbets is no excuse for causing significant financial losses to these retail investors and once again giving the upper hand to the large institutional investors that are thought to control the markets. But for Robinhood, the decision to hamstring the Redditor’s plans to carry out their attack, whether justified or not, carried an air of betrayal that the CEO would have to work hard to extinguish.
Vladimir Tenev missed his opportunity to save Robinhood’s reputation and win back the trust of his customers and the general public because he lacked the empathy to explain in a simple enough way, the risks to his company and the financial markets that the Redditors were creating. It is quite amazing that a market that seemed completely unfazed by a global pandemic that has killed over 2 million people now has the jitters because a group of individual investors on Reddit have potentially found a way to ‘stick it to the man’. This battle between the electronically liberated younger generations of the world and the traditionally rigged elite-controlled stock market has captured the attention of the entire world over the last week and it remains to see who will prevail. In my opinion, Robinhood may have ruined their chances of being a major player in what I believe is the early stages of a growing power struggle between the haves and have nots.