I thought it would be a few more days before I have anything interesting to say…but, on the other hand, the GameStop “problem” didn’t even exist a few days ago…
So things were and are, definitely, evolving quickly.
The financial system responded aggressively this morning to diffuse the GameStop fire.
While the SEC and a number of politicians and government agencies all indicated they are investigating the “issue”, most of the action occurred at the brokers with many of them preventing retail traders from further buying GameStop (and a few other stocks targeted by Wall Street Bets traders).
This is surprising because Robinhood was ground zero for a lot of this retail trading…In addition, Robinhood has also been one of the biggest drivers of retail speculation in options since Robinhood not only has looser controls than other brokerages when it comes to options but also fairly aggressively nudges users toward it.
It shouldn’t be a surprise then that once retail traders are not allowed to buy GameStop stock, the stock would fall:
Source: Google Finance
This makes sense because GameStop stock was largely going up because retail traders created an overwhelming demand for the stock from:
1/ Their own buying,
2/ The forced hedging that financial institutions needed to do in order to neutralize retail call option buying,
3/ Short sellers running for the exit and buying stock to cover their shorts.
Without the ability to buy, all of these forces suddenly reversed.
Even worse, retail traders couldn’t sell to other retail traders because the brokers did not allow other retail traders to buy (even for someone that didn’t have a position and wanted to get in). The retail traders could only sell to professionals, which obviously thought the stock was worth a lot less.
There is a lot of wrong that happened…And obviously no one is particularly happy about the situation, especially for those unfortunate retail traders that bought the stock at $300-500 and was then forced to unload at $150-250 to the very professionals that they wished to screw so much.
Yeah, that’s a bitter pill to swallow.
So is it over?
Sadly, this is hardly anywhere close to being over.
Because what happened was simply a band-aid.
What happened was only a temporary solution to the GameStop “problem”.
And it’s not even a particularly sustainable or repeatable solution since the brokers cannot indefinitely prevent retail traders from trading GameStop.
In fact, GameStop has gone back up quite a bit in after-hours trading because the brokers have started to allow retail trading, again, and will allow it tomorrow.
The key point here (and in yesterday’s post describing the ordeal) is that retail traders have come up with an innovative mechanism that short circuits the financial system. The problem isn’t GameStop or AMC or any stock for that matter…the “problem” is that retail traders have a mechanism to take advantage of the system in a way that cannot be stopped (easily).
So…the system can deal with GameStop…with some effort.
But then the retail traders can very easily just move on to the next target.
And the brilliance of the whole strategy is that retail traders don’t particularly care what the target is because it does not need to be anchored on fundamental analysis.
In fact, retail traders are already starting to spread to a whole lot of other things including silver and oil markets, for example.
The only thing that matters is that they have enough money (and / or a way of accessing leverage) and getting a lot of people to coordinate and do it at the same time.
The more and more I think about it, the more and more I think this is potentially a seminal moment in the evolution of the financial market.
Similar to the how the internet broke journalism, we could be at the critical turning point where retail traders have found a way to break the financial markets as we know it.
The internet ultimately democratized distribution, which was the key source of power in journalism. Once distribution became readily available for anyone and everyone, journalism lost its power to decide what everyone gets to read. This was both very good and very bad. On the good side, we got Wikipedia and an EXPLOSION of quality content across every single topic anyone can imagine. On the bad side, we also got a lot of fake news and disinformation.
We could be witnessing the very same thing in finance right now. The source of power in finance, historically, is obviously money. The more you have, the more power you have. While the top 10% of the US still hold a majority of wealth (~75% of all wealth in the US as of 2019), the coordinated actions of the other 90% can not only match the buying power of the top 10% (especially if the money is further levered), it could overwhelm it because it is generally illegal for professionals / wealthy people to get together in a room and coordinate. Yes the top 10% have 75% of wealth, but if it’s not coordinated, it will have a hard time competing against 30% of the wealth that is coordinated.
For the little guys, it almost always seems like rules are designed to harm them (although, objectively, many rules are designed to protect the little guys…whether the rules accomplish that in reality is a different story), but in this case, the rules sort of seem to tie the hands of the professionals and wealthy.
What can the system do to fight back against this? I find it pretty hard to see what can be done…
So why now?
Interestingly, what is happening now likely could not have happened in prior cycles even if retail traders knew what they needed to do.
This is because the whole mechanism requires very tight coordination amongst millions of retail traders. This was simply not possible until the last 10 years. This was simply not possible until everyone has a smartphone in their hands that allow them to know in real-time where the retail swarm is going. For example, the Dotcom Boom / Bust was a crazy cycle…but that cycle was based on only TV stock talk (and even then the media is filtered through, theoretically, “professional journalists”…imagine how much crazier that cycle would have been if everyone could coordinate with each other in real-time without any journalistic filtering).
In addition, what usually ends the party for retail traders is that everyone gets in on bad stocks…and eventually many bad stocks go belly-up. This is why speculating in penny stocks is a loser’s game since penny stocks are all universally bad businesses.
Retail traders can all collectively decide that they don’t care what a stock is worth, but you eventually have to care if the company goes bankrupt.
What’s very magical about the environment we are in right now is that not only can retail traders coordinate far, far better than ever before, the Fed’s extremely loose monetary policy and extremely generous support for debt markets has made it nigh impossible for any company to go bankrupt.
This might not last forever, but the conditions right now are just damn near perfect for retail traders to carry out such a fascinating market short-circuiting strategy with fairly low risk (compared to normal) even for people that don’t really know what they are doing. If the company isn’t going bankrupt, who can really stop retail traders from just not caring about these sometimes important vitamins called “fundamentals”?
All they know, and all I know (and all you know) is that if they can keep buying the stock (any stock), it will keep going up.
That’s mostly what I have to say, but before I draw this to a close, here’s two other things worth considering:
1/ Why didn’t the regulator do something about it earlier? And why don’t they do something about it now?
I believe the regulator can’t actually do anything about it.
This is because the retail traders have put the regulators in an impossible position. At the end of the day, regardless of how much the little guys feel that the government is buddy-buddy with Wall Street, financial regulations are actually designed to protect the little guys for the most part.
But in the current situation, retail traders are buying very aggressive out-of-the-money call options, which makes it nearly impossible for the regulators to help them.
As a reminder, here is how a call option works. Let’s say a stock is at $10. You can buy the stock for $10…or you can buy a call option that gives you the right to buy the stock in the future at some predetermined price (the strike price).
An aggressive call option would be one where the strike price is a lot higher than the current stock price. Let’s say you want to buy a call option with a strike price of $20 that will expire in 1 month. This might cost you, say 10 cents. So if you pay 10 cents today (which is a lot less money than paying $10 for the stock outright), you get the right to buy the stock within the next 1 month at $20. This call option is aggressive because it is obviously worth nearly nothing if the stock is trading at <$20. Because you would never want to pay someone $20 for the stock if you can just buy the stock in the market at $10 or $11 or $12 or…even $19.99. Yes, you have the right to do it, but you would never logically want to exercise that right even if you have the right to do it. But if the stock is trading at $30 instead, well suddenly your options are worth A LOT because you have the right to still only pay $20 for that stock.
So from the regulator’s perspective, here’s what the situation looks like: A lot of retail traders are pushing up stock prices probably far, far beyond what it is worth. This is going to be potentially a problem. For example, maybe a stock like GameStop is worth $10-15 (I made this number up…so don’t go trading the stock based on this made-up “value” for the stock!) but it traded all the way up to $50 at the beginning of this week. As the regulator, you want to limit the risk that retail traders get burned…but you can’t because the retail traders you are trying to protect have call options with very aggressive strike prices (for example, maybe $60 or $100…or $200). You want to curtail the speculation, but if you stop the stock from going up and even further away from what it is worth, all of those call options become worthless. Those call options are only worth something if the stock actually continues to go up, up, and away!
So what can the regulator do?
If it keeps going, a lot of people will get hurt, including the retail traders. But if you stop it, you’re almost guaranteed to be hurting the retail traders you are obligated to protect.
This is actually a lot like the classic trolley dilemma:
Logically, everyone knows that the right thing to do is to pull the lever and kill the single person on the right-side track…but it turns out most people would just prefer to close their eyes and hope the problem goes away even if inaction leads to more deaths because at least they wouldn’t be responsible for directly pulling the trigger.
I think the regulator has this problem right now. They can’t do anything about it because it feels easier to clean up the mess after it blows up than to actively cause the blow-up right now even if blowing it up right now would lead to a smaller mess than letting it continue.
2/ The reaction of various platforms towards what is going on creates the perfect tangent back to what I had feared about the dangerous new ground we have entered when internet platforms decided to de-platform the far-right.
When Twitter, Facebook, Apple, Shopify, Amazon, etc all collectively decided to de-platform the far-right, Capital Flywheels cautioned that maybe we are all giving internet firms a power that we cannot fully understand and might not be able to take back.
So with that in mind, it is interesting to see these two things happen:
#1 Discord bans the r/WallStreetBets server, but new ones have sprung to life
Discord has banned the r/WallStreetBets server, the company confirmed to The Verge — but that hasn’t stopped hundreds of thousands of its members from forming at least two new servers where they’ve continued to pump stocks like GameStop, AMC and more to unprecedented highs, with GameStop in particular briefly hitting $483 a share on Thursday morning.Source: The Verge
#2 Facebook Shuts Popular Trading Group Robinhood Stock Traders Amid GameStop Frenzy
Facebook took down a popular Wall Street discussion group, Robinhood Stock Traders, in a move that its founder on Thursday described as backlash for conversations buoying shares of GameStop and other companies this week.Source: Gadgets360
What’s concerning about both of these events is that they did not get banned for their role in the GameStop saga, but rather for “hateful” content that happened to be posted to their channels:
Discord says it did not ban the WallStreetBets server for financial fraud — rather, it was banned because it continued to allow “hateful and discriminatory content after repeated warnings.” The Verge gained access to the server and can confirm the claim that users of the channel were spamming hateful language, including racial slurs.Source: The Verge
Allen Tran, a 23-year-old from Chicago who created Robinhood Stock Traders, said he woke up on Wednesday to a notification that Facebook had disabled the 1,57,000-member group. The notification, seen by Reuters, said without detail that the group violated policies on “adult sexual exploitation.”Source: Gadgets360
Capital Flywheels certainly believes there is no place for adult sexual exploitation or hateful and discriminatory speech in the world I would like to live in, but, still, it is worth considering whether we have granted the internet platforms too much power to wield that policing capability to shut down two channels on totally unrelated matters…since you and I know that Discord and Facebook likely would not even have bothered looking at the content in these two channels all that closely if it weren’t for the GameStop saga…
And a further question to consider – Why is right to shut down the whole channel rather than just remove the offensive content or remove the offending users. Why is it right to shut the whole channel down when millions of non-offending users have not violated any rules at all?
Unless of course, the content is just the excuse…
I continue to think we have opened a Pandora’s box that we won’t enjoy very much. It was politically expedient in the moment for the Left to let it happen, but only time will tell if the Left (and the Right) will have the power to control the powers that have been unleashed.