Mystery surrounding Robinhood app and GameStop price spike: Now unravelled?

COMMENT: No likely heroes in this epic generational clash

Babu Das Augustine, Business Editor

Wall Street short-sellers led by hedge funds have been fuming over the huge volatility in the share prices of a few stocks in the Robinhood-GameStop saga that will leave them poorer depending on the size of their exposure.

They are angry at a bunch of juveniles who have turned their game of high finance into a video game. Finance gurus and economists are complaining about how the new generation kids have ruined the sacrosanct price discovery mechanism of laissez-faire through app-based trading; regulators are yet to figure out how to fix it.

Villains and heroes

Every story needs a villain and a hero. Depending on which side of the narrative you stand, you could get different villains and heroes in this saga. Unfortunately, there is none. Being an absolute neutral party, I think the problem lies in the antiquated regulatory framework that governs the Wall Street and the inability of the market grandees to understand how technology can disrupt their cosy deal-making culture.

Short-selling to blame?

At the heart of the current crisis sits the practice of short-selling, which is legal across many markets. Short-selling occurs when an investor borrows a security, sells it on the open market, and repurchase it later for less money to pocket the difference. Short-sellers bet and profit by hammering down the price of stocks. It builds momentum in the downward spiral of share prices, hurting genuine investors while giving ample returns for short-sellers.

In August, a 34-year-old financial adviser from Massachusetts, operating under the pseudonym Roaring Kitty, posted a video on YouTube highlighting that certain hedge funds held huge short positions in GameStop (GME), with more than 100 per cent of the company’s shares sold short.

The shares were theoretically open to ‘short squeeze’ (a term for buying these short positions to bring a reverse momentum). A flood of buying could drive the stock price up, forcing the short-sellers to buy new shares to cover their existing positions, which would drive the stock price higher, in a self-perpetuating cycle.

Enter Reddit and Robinhood

On social media platform Reddit, many members of the WallStreetBets community began to buy up GameStop and other such shares that had huge short open positions. Robinhood Markets Inc., the popular commission-free trading platform, became the favourite of short squeezers to accumulate the shares that were facing shorting pressure. Huge volumes were traded as buyers charged ahead sending short-sellers on the backfoot to cut losses.

Nothing illegal so far. The shares kept surging to dizzy heights. But Thursday morning, the game took a different turn as Robinhood (along with some other online brokerages) halted new purchases of GME and several other stocks that had become the subject of similar shorts of social media-driven booms, including AMC Theatres and BlackBerry. These shares plummeted immediately, causing huge volatility.

While there was rampant speculation that Robinhood had bent to pressure from frustrated members of the Wall Street establishment, the allegation remains unproven.

Who is right?

What the Reddit group did to inflate the stock of companies like GameStop, AMC Entertainment and BlackBerry simply mirrored what the hedge funds had done in conspiring to short those same stocks and drive down the prices.

While both orchestrated short-selling and short squeeze amounts to market manipulation, until the regulators step in with new sets of rules to rein in this madness, there will be no winners. On the contrary, in absolute terms, unsuspecting retail investors will incur heavy losses on momentums in either direction.

Clearly, the GameStop saga has all the makings of the start of a disruptive generational clash and a battle for control of the markets. The US Securities and Exchange Commission has rightly stepped in to prevent anarchy, but I suspect the regulator will struggle to define which group is morally right.

Trading at your fingertips

Why Robinhood saga won’t happen in the UAE

Yousra Zaki, Assistant Editor — Features

The GameStop incident emerged as a result of the ease in access to the stock market by small investors, the availability of leverage (margin trading) that increased their buying power by many times and the fact that traditionally hedge funds that take short positions also use margin. As margin multiplies the profit or loss on your original capital it’s a game of Tic-Tac-Toe.

So a herd of small individual investors ganged up and simultaneously bought the share of GameStop pushing the price up and forcing margin calls on the Melvin hedge fund. This is known as a short squeeze and is a well-known strategy used by Wall Street’s big players that was borrowed by individual traders on social media chatroom platform Reddit.

The UAE stock markets, however, have very different rules than the international markets, that make such market-related incidents very difficult to achieve, said Avramis Despotis, the founder and CEO of Tradepedia.com.

While Robinhood would give leverage to anyone who deposits $2,000 with them and has a passport or utility bill in his name, in the UAE stock market margin is given under a more regulated environment with a stricter criteria.

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While Robinhood would give leverage to anyone who deposits $2,000 with them and has a passport or utility bill in his name, in the UAE stock market margin is given under a more regulated environment with a stricter criteria. For example, Emirates NBD requires the client having a trading history of more than 18 months and a minimum share portfolio value of Dh1 million, consisting of shares from a mix of a minimum of three different companies.

Furthermore, the margin requirements are much higher (Clients must deposit cash initial margin of 50 per cent to be maintained at 30 per cent level — compared with Robinhood’s lower requirements making the possibility of retail investors ganging up to target specific shares very low, Despotis said.

Additionally, restrictions on short selling like, if total shares shorted reached 10 per cent of its capital, market will suspend short-selling activities on the shares. Moreover, the high margin requirement limits the exposure of short-sellers, making them more equipped to withstand – orchestrated or not – short squeezes and have a more balanced approach, he added.

Leverage vs margins

And to really understand what happened with the GameStop incident an understanding of Leverage and Margin is essential. In a cash account, the maximum buying power is equal to the capital invested. In other words with a $10,000 deposit one can buy shares or currencies up to $10,000 and not more.

In a margin account, traders can take advantage of leverage to trade bigger positions than the value of their deposit. If the share you are trading has a margin requirement of 10 per cent then with a $10,000 balance in the trading account one can buy shares equivalent to $100,000 or more if the margin requirement is lower, say 5 per cent or even 1 per cent.

However, trading on margin can be a risky business because you invest with borrowed money. Moreover, if the price moves against you, your losses compared to your original capital are multiplied which can end in what is known as a margin call – i.e. the broker selling your shares to ensure you will not lose more than the margin amount you have in your account.

Why small investors in the UAE prefer trading apps

Mariam M. Al Serkal, Associate Editor

Free trading apps are a hassle-free deal for small investors, who are self-reliant enough to work their way around stocks with the least amount of paperwork. But, how reliable are they? And more importantly, do they work?

Emirati investor Fadhila Khansaheb is a staunch supporter of trading apps, and explained to Gulf News how a number of brokers in the UAE have adopted the global trend in providing apps; making it easier for investors to trade.

"It allows people who prefer to trade by themselves another method of trading, but many investors in UAE still prefer to speak with a broker for trading. Having an app also allows investors to choose another alternative method to trading, she said, while emphasising that the current apps available in the UAE are safe, as the Abu Dhabi Securities Exchange (ADX) and Dubai Financial Market (DFM) monitor all transactions.

Khansaheb pointed out that another leading factor to the safety of investment apps is down to the fact that all companies operating in the UAE have to be regulated by the Securities & Commodities Authority (SCA) and Central Bank, and also have to be registered with ADX and DFM. “That is one of the reasons why I trust brokerage firms and brokerage firm apps because the market can literally see everything and track all the money, which makes it reliable,” she said.

Privately-owned investment apps that are part of a registered broker in the UAE should be safe because these brokerage firms are registered and monitored by the SCA, as well as the Central Bank. I am not aware of any private owned apps that are not affiliated with a brokerage firm.

- Fadhila Khansaheb, Emirati investor

“Privately-owned investment apps that are part of a registered broker in the UAE should be safe because these brokerage firms are registered and monitored by the SCA, as well as the Central Bank. I am not aware of any private owned apps that are not affiliated with a brokerage firm.

“I personally use the trading app provided by EmiratesNBD Securities and sometimes call a broker to trade, especially when it comes to technical difficulties, which can happen from time to time. It is easier to speak to a person to execute the transaction.

“I will not feel comfortable using a private app that is not registered with the Central Bank and the SCA. It is a risk putting your money in something that is not regulated,” she added.

Big data, fintech and the retail investing revolution

Jay Hilotin, Senior Assistant Editor

What could be better than free? Today, market apps allow millions of retail investors to trade stocks, derivatives and other assets while on a holiday, or in a lockdown. So buying and selling stocks, bonds, exchange traded funds and — commodities like gold and oil — are no longer the exclusive domain of finance behemoths.

Millions of new entrants with as little as $200 had been pulled into capital markets. Powered by AI, with little human intervention, these apps offer hassle-free sign up. You can actually start to place buy and sell trades with no money involved, through what is known as "virtual accounts".

And yes, most of these apps are free. Here’s a low-down on the Robinhood and GameStop frenzy — the unraveling mystery that surrounds the saga.

What is shorting, or short-selling?

Investors who bet against a stock are called “shorts.” Short selling is sometimes called “investing in reverse”. In simple terms, short selling is capitalising on falling share prices. The strategy is one part “contrarian investing,” and one part “short-term profiteering.” This is a radically different investing approach that can earn big short-term profits. It is based on speculation that the price of stock or another security would slide. You make money if you correctly guessed the price drop.

"Shorting a stock" essentially means borrowing shares from a broker and selling them, with the agreement you’ll return the shares later. When the price falls, you buy back the shares and pocket the difference.

What's the logic behind making money from shorting?

Throughout the 20th century, stocks historically rose just over 11 per cent a year. Yet individual stocks routinely dive by that much or more — in a single day. So, instead of waiting for years for an 11 per cent profit, you can potentially earn these kinds of returns in a matter of days during a stock sell off. Even in bull markets (markets that are persistently rising), there could be plenty of opportunities for short sellers, as in during a profit-taking period, when investors sell share to book profits, thus depressing prices.

Who invented short selling?

The practice of short selling started in 1609, when it was invented by Dutch businessman Isaac Le Maire, a shareholder of the Dutch East India Company (Vereenigde Oostindische Compagnie or VOC in Dutch).

Why is shorting risky?

Shorting a stock is inherently risky. You could be right today (stock falls). But if the price rises tomorrow, you can lose big time. Moreover, you can lose if someone (or a group) jockeys the share price up — by buying a lot of shares — even if the company's balance sheet shows nothing that would interest an average investor.

This is called "short squeeze". Shorts have to close their position — that is, buy up the shares they owe their brokers and return them. This demand kicks the stock price even higher, and a "short" who acts too late could face financial ruin. Usually, these kinds of standoffs involve sophisticated Wall Street investors. Now the retail investors too have jumped in.

What are options?

Options form part of a class of investment instruments known as “derivatives”: They derive their value from an underlying asset, i.e. stocks, bonds, exchange traded funds (ETFs) and mutual funds. Sophisticated iinvestors use options for income (making money, of course), to speculate, and hedgeing.

How do options work?

Options are contracts that give investors the option (right) to buy a stock at a certain price at a future date. If the price rises, the trader can buy the stock at a bargain and sell it for a profit. (Many traders just sell the options contract itself for a profit or loss, instead of actually buying the shares, but this description suffices for our purposes.) In an options contract, the brokers that sell the contracts must provide the shares — if the trader demands the share (or exercises the option). To mitigate their risk, they buy some of the shares they might need.

Such "cover" trades don't affect the price, on a normal trading day. However, when more traders bet big, the demand can push the stock up. If it goes high enough, the brokers who face losses must buy more shares, or they could face a bigger squeeze, having to buy high-priced shares all at once. That increases demand, which increases the stock’s price. Which means the brokers have to buy more shares...the cycles goes on.

This is what happened to a big hedge fund investors who shorted Tesla shares, thinking the company would sink and EVs are just a passing fancy. Tesla is still one of the most shorted US stocks. In October 2020, S3 Partners calculated there's $23.4 billion worth of Tesla stock (TSLA) shorted.

What are the types of options?

In the most simplified term, an option is a contract that gives the buyer the right (option) — but not the obligation — to buy or sell the underlying asset at a specific price on or before a certain date. Derivatives, on the other hand, is a more general term for contracts, or financial security, with a value derived from an underlying entity, asset or group of assets. Examples of underlying entities/assets for derivatives:

• Stocks
• Bonds
• Commodities
• Currencies
• Interest rates
• and market indexes

They are often simply called the “underlying".

Put option vs call option: What’s the difference?

Simple: A call option gives the holder the right to buy a stock; a put option gives the holder the right to sell a stock. Think of it this way so it’s easier to remember: when you place a call option, you buy (call=buy). With a put option, you sell (put=sell).

Can a person who bought an option use it or make money out of it before expiry date?

Yes. Before an options contract expires, investors have several moves they can do, including:

Can options traders fix a stock price?

Yes. Options enable an investor to fix a stock price. In a move similar to getting something by paying a deposit (i.e. putting something on “layaway” — paying a deposit to secure an article for later purchase), option contracts let investors freeze the stock price at a certain amount. This is called the “strike price”, with the important caveat that it’s set for a specific period of time. Depending on the type of option used, it guarantees that investors will be able to buy or sell the stock at the strike price any time before the option contract expires.

What are the pros of options?

There are five key advantages:

And the cons?

The downsides can be huge, including but not limited to the following:

How did options trades play out in the GameStop stock price frenzy?

Put options that pay out if GameStop’s shares fall below 50 cents within a year were the most popular options tied to the stock on January 28, 2021, with nearly 33,000 contracts changing hands, Reuters reported. It said traders may be buying these puts in conjunction with other options contracts. The sharp moves in GameStop shares have boosted the stock’s implied volatility and inflated the price of options contracts.

What is hedging?

Hedging is a risk management strategy. It’s used to offset losses in investments by taking an opposite position in a related asset. Though it’s considered an advanced investing strategy and not quite widely understood, hedging principles are quite simple. For example, people hedge every day, often having nothing to do with complicated derivatives or stock market trades.

When you buy insurance (life, car, unemployment) to support your family in the case of death, accident or loss of employment, it’s a form of hedge. An insurance contract costs money (usually in monthly sums for the coverage provided by an insurer). The textbook definition of hedging is an investment made to limit the risk of another investment.

Many hedge funds, by contrast, take on the risk that people want to transfer away. By taking on this additional risk, they hope to benefit from the accompanying rewards. Hedging strategies typically involve derivatives, such as options and futures contracts.

What is a hedge fund?

A hedge fund is an investment pool, typically a limited partnership (or LLC), that tends to be higher-risk and is reserved for wealthier investors.

What is Gamestop?

GameStop is a video game retailer in the US. It has shops in most US malls.  

What’s Robinhood? Where is it based?

Robinhood Markets, Inc. is an American financial services company headquartered in Menlo Park, California. It is regulated by Financial Industry Regulatory Authority (FINRA) under the broker-dealer category. It is registered with the US Securities and Exchange Commission (SEC), and is a member of the Securities Investor Protection Corporation.

How did GameStop saga start?

Some put to the blame on Reddit’s Wall Street Bets (WSB) forum, whose members talk to each other, share trade tips and kilometric analyses. In late 2020, GameStop’s shares saw a spike, after the founder of the pet-supply site Chewy bought GameStop’s stocks and got a board seat. This kicked up chatter in WSB and among traders who frequent the gamer-friendly social media service Discord. The traders had nothing in common. Some think GameStop’s shares are a good value. But it's not just small-time investors. Wall Street's big funds also jumped in.

What is the Robinhood fiasco all about?

On the surface, the craze showed how day traders used Robinhood and other such apps to “squeeze” the hedge funds. But, the squeeze also ended up battering their beloved brokerage.

What is a “short squeeze”?

Essentially, it’s betting on the wrong stock or asset that forces short-sellers to take flight. Their impact on the stock's price is known as a short squeeze — as they are literally being squeezed out of their positions, usually at a loss. Short sellers zero in on a stock that they think is overvalued by the market. A short squeeze occurs when a stock moves sharply higher, prompting traders who bet its price would fall to buy it in order to avoid greater losses.

What were the hedge funds affected? What role did hedge funds play in the Robinhood fiasco?

Melvin Capital and Citron Research were affected, according to US media reports. Due to the short squeeze, Melvin Capital reportedly needed a $2.75 billion of cash on Monday, but a spokesperson stated its short positions had been closed. Andrew Left of Citron stated he had covered the majority of his short position “at a loss, 100 per cent.”

How were the Robinhood investors affected?

The short squeeze of hedge funds demonstrates how an app like Robinhood, E*Trade, Trading 212, DT Ameritrade and others could be weaponised by activist small investors acting as a “pack”.

What were the other companies affected by the trading halt?

How much did it cost the small investors?

By some estimates, the Reddit-driven assault on hedge funds has cost small investors $20 billion — in paper losses, after Robinhood suspended buying of stocks such as GameStop, cinema chain AMC, BlackBerry, and others on January 28.

What then happened to Robinhood?

Robinhood was caught in the eye of the GameStop storm. Its troubles came in the form of regulatory compliance. On January 28, 2021, the Depository Trust & Clearing Corp. (DTCC) — the stock market’s central clearing hub — demanded significantly more collateral from member-brokers. By the end of Thursday, DTCC collateral requirements from brokerages, including Robinhood, jumped from $26 billion to $33.5 billion. Robinhood’s retail investors (the company has reported 13 million members), had inflicted billions of dollars of losses on hedge funds by launching a sort of “pack attack”, i.e. collectively buying up the shares of GameStop, thus jacking up its stock price. This has severely hurt the firms that had “shorted” the stock (i.e. speculated on a price drop). Robinhood was also hit. It was forced to raise $1 billion from shareholders on Thursday itself to cover for reported losses. A few days later, Robinhood took another $2.4 billion from backing in a funding round led by Ribbit Capital and also includes Iconiq Capital, Andreessen Horowitz, Sequoia Capital, Index Ventures and NEA, Robinhood stated.

How was Robinhood affected by the GameStop stock price craze?

Robinhood was badly affected. Its co-founder Vladimir Tenev said they had secured the $1 billion cash injection from backers on January 28. The company said it required to allow its users to resume their buying spree the next day. GameSpot shares had plunged on Thursday, after Robinhood barred users from buying more stocks of the company, which triggered the Reddit rebellion.

Was the move to shut down buy trades unfair?

Many members of the 4.8 million-strong WallStreetBets forum on Reddit who have bought GameStop shares fumed after the trading platform shut down their ability to buy, leaving them with only sell trades. The company said its temporary shutdown of buy trades was due to the demand for collateral by the DTCC.Robinhood users said the move was unfair, arguing that they (small or retail investors) are being shut out of the market, while big hedge funds were not.

What did Wall Street bigwigs and lawmakers say about the squeeze craze and eventual trading shutdown?

Wall Street bigwigs attacked small-time traders for messing up the market by artificially inflating prices, and turning investing into a video game. Dire warnings of "painful losses" for retail investors were issued. While the finance gurus attacked the "extreme volatility" in the market, politicians like US Rep. Alexandria Ocasio-Cortez (OAC), a member of the finance committee, has threatened to hold hearings. The US SEC promised to investigate. There are calls for a US congressional probe.

Even Tesla's Elon Musk chimed in.

Meanwhile, except for the wildly inflated stock price, not much has changed for GameStop. No doubt it's a highly volatile, high-risk asset for whoever owns its shares. The controversy continues to grow, which may iturn it into one of the longest "short-squeeze" episodes. 

When did Robinhood restore buying of shares of GameStop, AMC, Blackberry and others?

On Friday, January 29. Despite the decision to permit what Robinhood said would be “limited buys”, this resulted in GameStop’s shares climbing — again — more than 67.6 per cent on Friday, taking its market valuation to more than $22 billion. It was nearly 80 times what it was worth in January 2020.

What other trading apps put blocks on buy trades of GameStop stocks?

Other smartphone trading apps — such as Trading 212, E*Trade (owned by Morgan Stanley) and Interactive Brokers Group Inc. took similar action on Thursday (January 28). The platform TD Ameritrade, owned by Charles Schwab Corp., stopped the trades on Wednesday (January 27).

What happened next?

The collective move by online brokers saw GameStop stocks tumble from a high of $492.02 to close at $193.60.

But what’s with the continued rise in GameStop stocks?

Analysts are asking the same questions. At the moment, they call it a “mystery”. First, they cited data from Citadel Securities (process more than 40 per cent of US retail stock trading volume), which showed retail traders were “net sellers” of GameStop shares last Tuesday and Wednesday.

Did the institutional investors jump into the bandwagon?

GameStop shares still went up 68 per cent higher on Friday, through many retail traders were restricted (which meant they were unable to continue the push the stock price up). One scenario: The possibility of big institutional investors already in the thick of the GameStop fray, a Forbes report states.

Who are they? And when is this going to stop? Did the GameStop saga open a Pandora’s Box?

These are the questions swirling around the global investment community. And a little detail could complicate the story, and may become the centre of it all. There are still many unknowns today. Such unknowns pose a big downside risk for the small investors sticking with GameStop. And it’s one reason why US Securities and Exchange Commission and some US legislators threatened to conduct a review and penalise anyone in breach of the US securities law.

Meanwhile, speculation is rife that when the GameStop bubble bursts (i.e. when its stock price dives, as is expected) loads of retail investors would lose their life savings.

What’s the relationship between Robinhood and Citadel Securities?

Robinhood and Citadel’s relationship has come into focus as US regulators vowed greater scrutiny. Robinhood is based in Silicon Valley, California. Citadel is based in Chicago. Both are known to have worked closely to share users’ market data and build political influence.

A Washington Post report on January 30, 2021 states that Robinhood makes a large amount of revenue from Citadel, a financial-services giant. Robinhood’s regulatory filings show the company charges large investment firms (known as “market makers”) fees to access real-time information about which stocks its users are buying and selling.

This story points to a practice may expose both Robinhood and Citadel to a potential conflict-of-interest equation, the report said, citing “regulators and industry watchers”. The filings show Robinhood routes more than half of its customer orders to Citadel, by far its largest market-making partner by volume. The app also works with Virtu, G1 Execution Services, Wolverine and Two Sigma.

Will Robinhood’s relationship with these “market makers” face regulatory scrutiny?

It’s one possible scenario. Robinhood’s relationship with these investment firms is likely to face fresh scrutiny. After the trading halt, Reddit users accused Citadel and its billionaire founder, Ken Griffin, of pressuring Robinhood to limit trading of certain stocks, a move that may have prevented further losses for the short-sellers that lost billions betting against GameStop.

Who is Ken Griffin?

Kenneth Cordele "Ken" Griffin, 52, is an American billionaire hedge fund manager, entrepreneur, and investor. He is the founder, chief executive, Co-Chief Investment Officer, and majority owner of the investment firm Citadel. Citadel operates with an estimated $35 billion in investment capital. The Harvard-educated finance whiz father-of-three has an estimated net worth of $21 billion (as of December 2020). He drew the ire of retail investors after Robinhood took the extraordinary step on January 28 of limiting trading of stocks that were propelled to meteoric heights by conversations on Reddit message boards.

Was there fraud involved?

It's up to the regulators, such as the Financial Industry Regulatory Authority (FINRA) and the US Securities and Exchange Commission (SEC) to take a call on this.