Changing the Game / What’s Going On in the Market

What’s happening in the market is fascinating.

While Capital Flywheels had already been concerned about rising excess in the market and warned about potential volatility, the mechanism by which this is all playing out is actually quite different from what I was expecting.

In case you have not been paying attention, retail investors (i.e. non-professionals) have really taken an interest in investing over the last 9 months. And retail investors (of which I consider myself one when it comes to the Paper Portfolio and my own personal account) has made a very large splash.

Historically, retail investors don’t have much influence on the market (except at bubble tops) because the collective pool of money that retail investors allocate is fairly small, at least in comparison to the professionals.

In addition, retail money is spread out across much more people, which makes coordinating that money quite difficult. $100 million in the hands of 1 small hedge fund can be used to influence a small to mid-sized company’s stock price, but $100 million in the hands of 10k retail investors means less coordination and less ability to impact the market because that $100 million is unlikely to be channeled into the same one or two stocks. That $100 million in the hands of 10k investors could very easily be spread across hundreds or thousands of stocks, which means…it ends up being a drop of water in the vast financial ocean.

But more importantly, retail investors historically tend to lose out to the professionals because investing is mostly a game about knowledge and prediction. Professionals that spend all day thinking about investing tend to end up with better results over time because most retail investors don’t have all day to think about investing.

And this is before discussing the somewhat unfair advantages that professionals have including vast sell-side investment banking networks that help gather information useful for making decisions, as well as being able to speak with company management teams periodically. Yes, they pay for it…and, yes, it is illegal for them to use any material inside information they come across, but over time, professionals still build up a soft advantage based on thousands of little and immaterial things that allow them to understand a company just a little better than others. (Of course, there are those that cheat and use inside information, but most of them tend to get caught eventually…and when that happens they can spend some time in jail actually doing the thinking they tried to avoid in the first place).

So from a retail investor’s perspective, it’s easy to see why the game feels rigged.

For the most part, the game isn’t rigged in the sense that professionals are cheating (most are not cheating), but it feels rigged in the sense that the rules are defined in a way that retail cannot excel at.

This is fine if investing is like curing cancer.

Definitely leave that to the professionals…

But investing is not like curing cancer. It’s pretty hard for anyone to just drop their finances on someone else and say, “Here, do it for me” without paying a very high price. And for the professionally-managed funds that the average person can buy, they’ve done pretty poorly…

So…most of us end up having to manage more than we realistically should because the alternatives are not that great.

This sounds like a broken and rigged game!

And wow retail investors are fed up.

But it turns out retail investors could and did come up with a pretty fascinating solution to the problem!

As mentioned above, investing is mostly a knowledge and prediction game. But it isn’t only a knowledge and prediction game.

Like anything on this planet, the price is a function of supply and demand. Supply and demand usually correlates with the value of whatever the thing in question is. Usually people don’t pay too much more or less than what something should be worth, but nothing says you can’t pay whatever you want, underlying value be damned.

If there is a lot of demand for something, prices should go up.

A couple of months ago, fed up retail investors simultaneously resolved all of these problems at once and created an investment firestorm quite like nothing that Capital Flywheels has seen before.

Retail investors can’t coordinate? No problem! Coordinate over the internet!

This is essentially what happened through Internet forums like Wall Street Bets on Reddit (I assume you are well aware of the mania in GameStop stock already…but if not, Google it! All a result of Wall Street Bets forum…) as well as on Twitter and Tiktok.

Technically this is illegal if a bunch of professionals got together in a room and did it together, knowingly.

But I’m sure the SEC and regulators are as confused as us as to whether it is illegal when a bunch of people on the internet get together and decide to do this. And make decisions solely on the belief that others will follow.

Secondly, retail investors don’t have as much money? No problem! Instead of buying stocks, everyone can just buy call options!

In case you are not familiar with call options, it allows you to buy the stock at a future time at a predetermined strike price. Unlike stock, you are not paying for the stock when you buy a call option. You are only paying a relatively tiny amount of money in order to have the benefit of potentially paying up the big bucks for the actual stock at some future time.

The result of this is that a retail investor can get exposure to stocks without putting that much money up upfront. So instead of using $1000 to buy a small amount of stock, call options allow you to use that $1000 to potentially buy perhaps $5k to $10k worth of stock in the future. What it does is add leverage to the money. It makes it riskier, but if it works, the returns are multiplied. With each successful option investment, the pool of money that retail investors can play with expands exponentially.

The other secret that retail investors sort of figured out and hacked is that they figured out how market makers predictably act when it comes to options. When financial institutions are involved in the options market, they hedge their risk by buying or selling the underlying stock.

Wow was this a big hack. Retail investors figured this out pretty quickly. Don’t have enough money to move the market? Well let’s get the market makers and financial institutions to do it for them instead! Co-opt them! By buying call options, it causes the market makers to predictably buy the underlying stock!

So now there are millions of coordinated retail investors that are using leverage through call options in order to push back against professionals and taking advantage of predictable behavior to make financial institutions spend their money to benefit the retail investors.

And the kicker?

Retail investors are fed up that it is a knowledge game. Retail investors are refusing to play that game (“since it’s rigged!”). Retail investors decided to change the game.

…To a game that is only about supply and demand.

If retail investors coordinate and channel their money into whatever they want, it goes up simply because demand is overwhelmingly high! Who cares what the value is…who cares what the fundamentals are. What are fundamentals? Are those vitamins?

This is where we got to by the end of 2020.

Retail was fully in command of the market.

Capital Flywheels spent a lot of time thinking about how this can unwind. The only realistic scenario I could come up with is that something unpredictable (perhaps geopolitically) would cause the market to unexpectedly fall. If this happens, a lot of call options might suddenly become worthless. And if that happens, a massive amount of leverage would immediately disappear from the markets. This would be pretty painful and cause stocks to decline.

But! Retail investors were fully in control otherwise! How long would it take before such an unwind would happen?

It turns out reality would be even weirder than I expected.

In recent weeks, fed up retail investors decided that…instead of just investing in any random stock that tickles the mind, why not go screw some of these professional investors and show them who’s boss…

Wall Street Bets has been dominated with retail investors looking for crowded shorts (stocks where a lot of shares have been shorted, usually by professionals). The idea is that if they buy a lot of the stock and drive it up, not only would they make money, they would royally screw over the professionals that are short the stock.

When this started happening, the obvious conclusion is that stocks would go through the roof. If professionals are forced to close out their short positions (which is accomplished by buying the stock), everything would go up even more! Because not only are the retail investors buying…the shorts would also be buying, too.

But, wow, did reality turn out to be different. As this process started a few days ago, it turns out that it would make the market go down. This isn’t because the pool of money or leverage available and employed by retail investors changed (it has actually grown), but because professionals employ leverage of their own. Usually this leverage is achieved by shorting stocks and taking that money and investing it in something else. If a professional is forced to close out their short position, it also means that they will have a harder time maintaining their long position in whatever stock they bought with the money coming from the short position.

So…by targeting the short positions for the lulz, retail investors may have killed the golden goose this time…

Because now the professionals are forced to deleverage.

And this is bringing the whole market down.

The stocks that retail investors have targeted like GameStop is still up…

…But if the overall market goes down too much, it may cause options on these other stocks to become worthless, too (for example, I’m sure a good number of retail investors have call options on Tesla that may become worthless…). And that would also eventually impact retail investors.

What happens from here?