Using the social media platform, Reddit, a band of day traders targeted flailing companies like GameStop, AMC, and Blackberry and bought massive amounts of stocks that caused prices to skyrocket, roiling the market and imperiling hedge funds that had bet those companies would fail.
Paul Borochin, assistant professor of professional practice in finance, and Marcelo Zinn, an alumnus and president of Maredin Wealth Advisors (MWA), examined the factors that are fueling this “flows vs. pros” rivalry—or retail vs. institutional investors—and commented on the impact on the stock market and the economy. Borochin is also a financial adviser with MWA.
Who are the major players and what are their interests?
Borochin: The story is definitely set up as retail vs institutional investors, but order flow is not transparent and some institutions like Senvest Capital traded alongside the retail investors and vice versa. One example of institutions adopting the kind of trade that retail investors used to push up stocks like GME is the "NASDAQ whale" trade put on by SoftBank last summer in tech stocks.
Zinn: Exchanges—Nasdaq, New York Stock Exchange
Brokers—Interactive Brokers, Schwab, TD Ameritrade, Robinhood, etc.
Intermediaries —Citadel, Blackrock (Buy order flow)
Hedge Funds—Melvin Capital, Point 72, several others
Smaller players—Individual investors. Reddit’s wallstreetbets
What factors prompted this wild trading turbulence?
Zinn: Numerous factors in a very dynamic environment have prompted this situation. They include a combination of stimulus checks that have led to lots of new market interests from smaller investors, which has led to the rise of Robinhood traders utilizing platforms such as Reddit and Twitter to attack hedge funds by building opposing stakes (using stocks and options) in companies with substantial short interest. This has caused several prominent hedge funds to suffer large losses and created a lot of turbulence in the market, which is causing a swift reaction from regulators, intermediaries, and brokers to try and push back against individual investors.
Interestingly, Robinhood’s action to block trading has destroyed its good name in one swift move and showed who they are really aligned with. Individual investors have taken notice and it doesn’t look good. I’m not sure they will recover from this episode.
Also, with more people at home and increased time and money to invest, it’s far more consequential the role of the Federal Reserve Board and easy money has caused asset inflation, which is most prominently observed in the stock market. All these companies with zero profits trading at huge multiples to sales is a direct result of bad FED policy, along with a few other factors.
Borochin: Markets are interconnected, and here two "squeeze" trades amplified each other and caused institutions to close existing short positions, but to do this they needed to sell stocks they had long positions in. The first squeeze trade was a short squeeze, which is a feedback loop in which short sellers faced with rising prices are forced to close out their positions by buying up shares. This causes the price to further rise, potentially driving other short sellers to do the same. This is further amplified by a second type of squeeze trade. This results from a popular way traders (both retail and institutional) can bet on price rises by buying call options—the right to buy a stock at a fixed price—which can earn outsize profits if the stock appreciates. Market makers that sell call options hedge the potential payout they would have to make to call option buyers by buying a fractional share of stock, and the way options math works out they have to buy dramatically more shares to hedge an option on a stock that rises in price. This was what SoftBank used to drive up tech stocks in the summer, and this is what amplified the short squeeze trade in GameStop and similar highly shorted stocks in the current episode.
How does this compare/contrast with previous stock market turbulence?
Borochin: The impact on the overall market has been pretty minimal, particularly in contrast with the March 2020 price crash or other macro-scale disruptions. However, the volatility index (VIX), which reflects how risky the S&P 500 index is, rose to 37—a level not seen since the November election. While this particular episode is likely past, since broker intervention on further buys in highly shorted stocks has blunted the momentum in coordinated trading against those positions, the market remains in a volatile position driven by uncertainty in stimulus, virus, and recovery prospects which means we should expect more high-volatility episodes in the future.
Zinn: While individual investor collaboration has occurred in some forms in the past, the technology is allowing it to occur quicker, more targeted, and in bigger scale. It’s also an interesting reversal of norms in the industry, as it has historically been hedge funds which benefited from the actions of individual investors.
While the market reaction to the current turbulence is interesting, it doesn’t really compare to past periods from an overall negative decline standpoint. However, it has helped make clear just how the system actually works and who actually has a business model on helping individual investors.
Furthermore, what we are seeing today, in my opinion, is just the beginning of what is likely to be an extended period of volatility. The market is trading at a high valuation, and depending on FED action, along with COVID and the underlying economy, we could see some significant movement. People need to be aware and position themselves accordingly, so they don’t get caught out in the cold without a jacket.
The “flows” introduced by the trading “gamers” are disrupting stock market fundamentals. What are these historic fundamentals now being ignored/disrupted?
Zinn: What you finally get to do now is peek behind the curtain and see the Wizard of Oz. We’re also seeing how leveraged certain players are (some hedge funds and individuals), as well as how order flow works and how shorting securities can wreak havoc on some firms with large positions.
In addition, the biggest effect has been normalization of some very dramatic short squeezes utilizing stocks and options. The options usage is the highest level ever on record. This is causing a lot of turmoil with trading and margins.
You never really see individual investors teaming up against hedge funds. This could potentially shift the market dynamics in a different way. And it will be interesting to see how regulators, exchanges, intermediaries, and brokers react to this shift.
Borochin: This episode shows that what we take for granted about market function isn't necessarily the way it is. Warren Buffett said the market is a voting machine in the short term and a weighting machine in the long term, which means that in the short term a group of traders persistent enough can make themselves right. Furthermore, the biggest disruption to the way investors generally understand markets came from brokerage intervention in disallowing "buy" trades while continuing to allow "sell" trades in highly shorted firms, which has not been in the interests of clients attempting the squeeze trade.
What’s the potential damage (to the stock market, etc.) caused by this democratization of online trading? Where is this leading?
Zinn: Lots of new regulations is probably the easiest thing to predict. However, there is no way to put the genie back in the bottle, which should be very beneficial for individual investors at the detriment to hedge funds and some other players. It will also impact some traditional stock market business and the manner in which stocks are promoted. How regulators and other participants react to this shift will be interesting to see—what a fascinating time to be investing.
Borochin: This may lead to a rethinking in risk modeling by funds taking short positions in the future, and likely further attempts to collude and move prices by small traders—a behavior which we have seen before in the dot-com and Roaring ’20s bubble periods.
What factors/scenarios might return the market to stability?
Zinn: No doubt that a big wash out of individual investors due to a major market decline will remove a lot of the froth we are seeing. But it will not eliminate what has come to be: the potential normalization with individual investors collaborating to move markets.
Stability is generally the result of good price discovery mechanisms in place. With all the FED manipulation along with easy money, rampant speculation, and other factors effecting the market, we are getting perverse markets.
Until the market is able to function without that influence, we will continue to see stability get pushed further off.
Borochin: In the short term, broker intervention on behalf of the institutional short interest in highly shorted firms will likely be the end of this episode, but market volatility is likely to stay with us due to more long-running macro themes like the durability of the recovery, prospects for further economic stimulus, and public health developments. Until we see more clarity on these larger themes, we're not out of the woods yet.
