There is an extremely concerning trend in the US market that is probably going to end in tears. The Robinhood app has created an army of totally inexperienced traders who are using extremely complicated financial instruments to trade stocks.
Robinhood was founded in 2013 on the premise of no trading fees and no minimum account values. This may sound like a good thing for retail investors (normal people who are active in the market), but the app has a dark side.
Through the use of gamification techniques in the user interface, trading becomes a game. Games are addictive. Then, Robinhood offers complicated trading instruments like CFDs and options. Option trading is an art in and of itself, practiced by traders with a deep understanding of mathematical concepts, volatility and probabilities, in addition to the usual trader skill set.
Options should not be the instrument of choice for inexperienced traders.
This army of investors can connect with each other via social media platforms like TikTok and Reddit. While the TikTok videos are often extremely cringeworthy and more comical than financially useful, the Reddit threads get a lot more serious.
In particular, a thread called r/wallstreetbets went into all-out warfare with a short-seller called Citron Research.
What is short-selling?
Short-sellers take “short positions” on shares, which means they take a bet on the share price dropping. Not just under-performing and limping along, but dropping.
Short-sellers borrow shares in a company and sell them, promising to return the borrowed shares to the lender at a later stage. If the price goes down, they can buy the shares later for a lower amount and return to the lender, pocketing the difference.
If the price goes up though, they start to lose money and need to cover the position by buying shares. Whilst the profit on a short is limited, the losses are not. A share cannot go lower than zero, but has infinite theoretical upside.
Famous short-sellers like Citron Research or Viceroy usually support their trades by releasing research on why they think a particular company’s share price should drop. In many cases, the objective is to uncover fraud in a company and profit from the subsequent collapse in the share price.
The best-known example in South Africa is Steinhoff, which Viceroy successfully collapsed with a research report that sent shockwaves through our market. They tried to do it again with Capitec but came up… well, short. It didn’t work.
Before we move on, you need to understand a “short squeeze”
One of my favourite quotes about the markets comes from John Maynard Keynes:
“The markets can remain irrational longer than you can remain solvent.”
If you take out a short position on a stock, you lose money every time the price increases. As it keeps going up, you are required to settle the difference. In other words, you can’t just hang around until you eventually decide to get out of the position after a few years. Short selling is nothing like long term investing.
A “short squeeze” is a short-seller’s worst nightmare. When a share price jumps higher, traders who took out shorts are forced to buy more to cover off their positions. This just creates further demand for the share, driving it even higher.
The technical workings of a short are beyond the scope of this article. The important lesson here is that a sharp rise in a share price can literally bankrupt a short-seller in a matter of days. This is a very high-risk game.
Traders watch for shares that have attracted interest from short-sellers. If enough traders climb in and buy the shares, the shorts can be squeezed out even if they may have been right about the valuation being too high. Irrational longer than solvent, remember?
Of course, these traders are also playing a dangerous game – how will they exit the position and take profits if there are no buyers for the overvalued shares? They need to try get out before the shorts are all gone.
Trading is a vicious game that takes no prisoners.
Exhibit A: GameStop
It started out harmlessly. A letter from an activist investor asked GameStop to focus on online sales to survive, rather than selling video games in stores. The company agreed and appointed the investor to the board. The share price rallied around 13% on 11th January.
The r/WallStreetBets community then got stuck in, causing the stock price to double over the next two days. Around that time, GameStop was the most-shorted stock on the entire market. Trying to force a short squeeze is not a new trading strategy, but the level of coordination and the persistence of the buyers in this case has been quite extraordinary.
On 19th January, Andrew Left of Citron Research then walked straight into perhaps the wildest ride of his professional life. Calling a drop to US$20 per share, he angered the community to such an extent that his Twitter feed was nearly hacked and he had to abort a planned livestream explaining his views.
There have even been accusations of threats to his family, which is truly shocking.
The Reddit community went hell for leather into the stock, driving it 69% higher before the New York Stock Exchange intervened and halted trading. We don’t know how much pain Citron Research took, but market data reported over $3bn lost by short-sellers in GameStop. They were found wanting against the power of Robinhood and social media.
Of course, this cannot go on forever. The shorts and the Reddit army will continue to dance. At some point, the Reddit traders will run out of steam and take profits. There will be short sellers who get in at the right time, just as the share price finally turns downwards (which it surely must – the current share price is totally divorced from the fundamentals of the company).
There will be winners and losers on both sides. The Reddit traders who don’t get out early enough will ride the price all the way back down, taking pain along the way.
The lesson here is that the markets can be fiery and complicated. When the elephants fight, the grass gets trampled. Try not to be the grass.