The Four Horsemen of the Retail Apocalypse
The GameStop Squeeze, and How We Got Here.
Note: This post is too long to fit in your email. You need to open it in a browser.
In case you’ve been hiding under a rock at the bottom of the ocean, the Great GameStop Short Squeeze was all over the news. There were a lot of opinions, hot takes, and blog posts flying around about this story but I was more interested in writing about one thing: how did we get here? Robin Wigglesworth gave me the idea to write about it. And he gave it a name.
The Four Horsemen of the Retail Apocalypse:
1. Free Trading
2. Social Media
3. Fractional Shares
4. Free Leverage
1: Free Trading
It all started back in 2013. Back then I had an account at Scottrade and I remember having to pay a $7 commission if I wanted to buy and sell stocks. News had just come out about a new startup that promised to change all that: Robinhood. From day one they wanted to make investing more accessible, more mobile friendly, and most importantly of all: free. They wanted to make investing more accessible to people who wanted to start investing, but who couldn’t afford to pay such high commissions on the small amounts they were willing to invest. Robinhood said they were “democratizing finance for all.”
They were mostly ignored at first. “There’s no way that could work! How would they make money?”
But by 2017, brokerage firms were starting to take notice. Not only were they competing with each other and other online brokerages, but they were now competing with this new disruptor who was taking too large a share of the millennial’s investment dollars. Fidelity, Charles Schwab, and TD Ameritrade started to cut fees.
The fear that their competitors showed in face of disruption was all investors needed to see to back Robinhood with even more money at an even higher valuation:
According to Eric Rosenbaum back in 2017, the war was already won. And you know what? He was probably right. Robinhood was forcing every other player to take a good, hard look at their own commission policies.
The brokerage firms had already made their own proprietary ETF’s commission free and reduced their other trading commissions, thinking that may be enough. Then Vanguard made another bold move in 2018:
They went from offering free trades only on their own ETF’s to 1,800 different ETF’s, including ones from their competitors. They were opening the flood gates. This forced other brokerage firms to act.
JP Morgan dropped another bombshell soon after that, with their own trading platform that offered free trades:
It would take another few months, but competitors came up with their own answer: more free ETF’s for everyone!
ETF trading was now effectively free for most people. I remember thinking, “Wow, I can basically create a portfolio of broad market ETF’s for free now?! This is awesome!”
Yes, I am a nerd.
I thought the “great fee wars” would be over for awhile, but Interactive Brokers had something to say about that in late 2019:
That ended up being the straw that broke the broker’s back.
By the beginning of 2020, commission stock trading would quickly collapse.
The fee war had ended, and the people had won. “Democratizing markets” had won. Robinhood had won. They had completely changed the investing landscape forever, allowing anyone and everyone easier access to the stock market.
However, this did not come without a hidden cost. Today, we know how Robinhood actually makes money, and they haven’t been very up front about it. They get paid for order flow, receiving money for each trade they direct elsewhere to be executed, and more off people trading options. Not only were they investigated and fined by the SEC, but also FINRA for best execution violations. Investors on their platform became the product. Robinhood was selling them out.
2: Social Media
The r/wallstreetbets Reddit page was started on January 31st, 2012. A day which will live in infamy.
But in fact the earliest post I could find was from 4/11/2012, where everyone starts placing their bets for latest earnings season, from an early user who has since deleted his/her account. I can only assume this is Jaime Rogozinski, the newly discovered creator of r/WSB, but who knows?
(PS: You can use this handy tool I found if you really want to dig in more on any Reddit page, including WSB)
While searching through the early posts, the first time I see the crazy gambling behavior we know and love wallstreetbets for comes from user americanpegasus:
Americanpegasus is still an active member of the community, and from what I can tell is considered a true wallstreetbets OG. As well as a crypto/Monero trader OG. He still posts often and as you can see from his tagline he’s working on his 6th account blowout.
But he can explain it in his own words:
Prestige mode indeed.
Over time, thanks to members like “americanpegasus” and others, the subreddit grew a following of aggressive options traders over the years:
There would be stories here and there about the wild antics of these degenerate traders. We all used to laugh at the stories of Reddit traders with no experience blowing themselves up, and they wore those blow-ups like a badge of honor:
But later people started to realize the traders on WSB were smarter than it first seemed. In late October of 2019, a Reddit WSB user found a glitch in the Robinhood app, one that allowed the user to borrow an unlimited amount of cash to put up for more trading. The Robinhood Gold account would allow traders to sell call options with with borrowed money, or leverage. But what Robinhood didn’t realize was the app would add the value of their leverage to their cash pile, allowing them to add more leverage, which the app would think was money added to their available cash, and so on. They called it the “infinite money cheat code,” allowing for infinite leverage on the platform.
Even then, they were successfully finding weaknesses in the system and trying to exploit them. And then used social media to tell everyone else how to do it.
There were also stories circulating about traders on their platform who were getting rich:
Outsiders started taking notice. The media wanted to interview them, ask them how they did it, praised their personal success stories and frowned on their crudeness and excessive risk-taking. They were the wall street vigilantes, punching above their weight, taking on the big boys.
In February of 2020, Luke Kawa did a cover story for Bloomberg Businessweek on the group responsible for the “guerilla warfare in the markets:”
In this article, Luke spelled out their process, the same process they would later use on the vulnerable short sellers of GameStop:
Members of r/WSB believe they’ve discovered a kind of perpetual motion machine in the interplay of stocks with options contracts, which offer a cheap way to bet on whether shares will rise or fall without buying the stock itself. It goes like this: Members make bets that rely on market makers, the professional middlemen who sell you a “call” (a bet on shares rising) or a “put” (a wager on a decline). Market makers, like good bookies, don’t want to go out on a limb. When taking a bet, they lay off the risk. If someone buys a call, for instance, speculating on a rally, the dealer buys stock in the underlying company. If the stock rises, the dealer may have to pay out on the option—but that’s offset by the gain on the shares.
When shares keep rising, managing the hedge entails buying more stock. That’s where the Reddit set perceives a weakness. A favorite tactic on r/WSB is to swamp the market with call purchases early in the morning in an attempt to force dealers to keep buying stock. Up and up everything goes—supposedly. As the stock price rises, so does the value of the calls, often by far more.
And some seemed to understand pretty early on that they could most certainly have more sway over smaller stocks:
Benn Eifert, chief investment officer at QVR Advisors, was initially skeptical that the money behind these online message boards could sway anything. He changed his mind. “At least from the dealers”—the middlemen—“they’ll tell you in big tech names, flows are substantial, and it’s moving things,” he says. Smaller stocks are even more sensitive to sudden bursts of attention.
They even had their legal defense already laid out:
Members are aware that questionable thinking underpins their bets, to the point of self-deprecation. After user SolTrainRnsOnHolGran wondered whether r/WSB’s activities might constitute insider trading, a user named recentlyunearthed replied, “How can we have insider knowledge when we don’t have any knowledge?”
But I know what happened here. We all read the story, laughed at the crazy wild west traders and moved on. Especially since, soon after this, we were hit with a huge pandemic. Our lives were upended and we lost interest in the wall street vigilantes.
Social media was being used to move markets, but Reddit wasn’t the only place where this was building up. Stocktwits and Twitter had already been around for awhile as the go-to place for traders to talk up (or down) the stocks they were watching. It was bound to happen at some point that a group of traders would band together, trade together, and coordinate their trades to get rich quick.
One could argue Twitter set this in motion long ago when they made the “$” symbol so you could search individual stock tickers. I know I’ve been using it recently: $GME
3: Fractional Shares
In the winter of 2015 a company with a new idea for issuing fractional shares had an idea to sell stock gift cards: Stockpile.
At the time, many of the most popular stocks were trading at over $100 per share, making it impossible for some to buy even one share of Apple, Google, Tesla, etc. Stockpile created a solution for this: buying fractional shares. Fractional shares used to only occur when there were stock splits or dividend reinvestment plans, but now you could buy a stock in nice little bite-size pieces. Stockpile would sell $25, $50, or $100 gift cards in stores so that you could finally own a piece of your favorite stock. You would own a “fraction” of a single share and be able to build up to a full share over time if you continued to invest with them.
The “micro-investing” movement had begun. Other companies would follow suit with fractional shares, such as Acorns, Stash, M1, and Betterment. These companies allowed people to buy into stocks and ETF’s in fractional amounts, getting them involved in investing early and often. At the time though, these were smaller Fintech players fighting against the bigger wall street brokerages for business.
Not much else would happen in the world of fractional shares until the fall of 2019. The larger brokerage firms realized younger investors wanted this extra flexibility and wanted to gain an edge in the “fee wars” mentioned earlier.
It all seemed to happen so fast. Fractional shares came in a a tidal wave:
Not only could you trade stocks for free, but now you could even trade fractions of a stock for free. What a time to be alive!
4: Free Leverage
Along with the trend toward free stock trading, Robinhood was also an early adopter of allowing free trading of a more risky financial instrument: options.
This is a relatively new phenomenon because no company has made it as easy and fun to trade options as Robinhood. Options can be used as a form of leverage because with the same amount of money you can buy more option contracts than shares of the underlying stock. While options can result in bigger and faster gains they can also lead to bigger and faster losses. Any change in the stock price affects the option price even more.
By now I’m sure there are many of you who may recall the story of Alex Kearns, the young man who thought he had lost over $730,000 on Robinhood and took his own life.
And what made this story even more tragic:
In a note left for his family, Kearns said he had “no clue about what I was doing” and never intended to “take this much risk”. Horrifically, it appears Kearns mistook the potential loss on one leg of an options trade for the outcome of the overall bet — wrongly believing that he had racked up a loss of $730,165. In fact, his account had a balance of $16,000.
I’ll be honest, I don’t even know what having “multiple legs of an options trade” even means, which probably means this is something a college student shouldn’t be messing around with.
After the incident, Robinhood tried to make changes to it’s platform:
Here are some of the highlights:
In designing this experience, we were deliberate about adding more safeguards and information. For example, before exercising an option, customers will be asked to review their strategy, associated risks, and potential reasons to not exercise the contracts, in order to help them determine whether exercise meets their objectives. We also display alerts and available actions when exercising a contract.
We recently launched additional in-app messaging to help customers better understand the mechanics of early assignment, in which a customer trading a multi-leg options strategy has one leg of the position assigned for exercise prior to the expiration date. We also recently began rolling out a new onboarding experience to walk approved options customers through the foundations of an options spread before upgrading from Level 2 to Level 3 options trading.
We're rolling out new financial criteria and revised experience requirements for new customers seeking to trade Level 3 options strategies. Robinhood requires customers wishing to trade options to disclose, among other things, investment experience and knowledge, investment objectives, and financial information such as income. Robinhood then conducts an assessment of this information in deciding whether a customer may be approved for options trading.
Do you see what I see? They aren’t really “limiting” options trading, and their safeguards seem like more of a “click ok to trade.” And they seem to have full control who gets Level 2 and 3 options trading, even though they’re economically incentivised to encourage more trading.
On top of this, new users are auto-enrolled into a margin account, which means they can take out a free loan from their broker for even bigger YOLO trades (with interest of course).
Sure, they have a pretty nice looking and thorough Knowledge Center on options trading but does anyone actually read that if they aren’t forced to? I doubt it. Maybe some do. But even if one person doesn’t, they lose their shirt and have no idea how or why it happened. These are regular people, not hedge funds.
Then suddenly all these factors came together, and something big happened this year:
I think you know what. The GameStop Short Squeeze.
Which then turned into the GameStop Gamma Squeeze.
First, they laughed at them. Now they fear them:
So what does this all mean?
Overall, I think it’s a good thing to give people easier access to the markets through things like free trading and fractional shares. I know what it felt like back in 2012 when I started trying to do this stuff on my own, and it was hard to make a decision on what to do with my $500 or $1000 I wanted to invest. It sucked. It felt like if you made a mistake, well great now I just lost $14 because I sold out of that dumb stock I read about on Motley Fool! It was not a fun introduction to investing. It feels like death by a thousand cuts, especially when you’re starting out early, still learning the ropes, and are most likely trading too often as most early investors tend to do.
Even if you lose money in the market, it’s not the same feeling, or the same mental accounting, as paying a fee.
A fee is “pay to play,” whereas losses are the tuition you pay.
I think “tuition” in this context includes things like selling order flow or how high frequency trading works and why you should use a limit order. These are things you learn over time, and overall aren’t that harmful to people investing small amounts of money for the first time. While brokerages aren’t exactly forthright about it, it also doesn’t make you feel like you can’t buy a stock like an upfront commission would. It’s a psychological barrier to entry.
Also, let’s be honest here, I like that I can rebalance a portfolio at any time without having to worry about commission fees.
So today everyone has access to free trades, social media, and fractional shares, which I don’t think are inherently bad things (most of the time). One of the bigger problems I have in the US are the amount of people who don’t own any stock:
If anything, I would like to see this percentage go up, not down. I think it’s the best path to wealth. It needs to be done in the right way though. It needs to be taught in the right way.
In other words: investing shouldn’t be turned into video game.
Which brings me to individual investors having easy access to options trading and leverage (LOUD SIGH). I don’t think retail investors and traders should have access that is THAT easy to ANY available option contract or margin account, at least not without the right safeguards.
This could be an opportunity for Robinhood to institute a “just-in-time-training” system for people who open new accounts, so they can be stopped and taught about the potential outcomes, more than the “click ok to trade” notification they have now (which obviously hasn’t seemed to work). They could add a short trading course or quiz before your first options trade. If I was someone curious about options trading, but didn’t really know what I was doing, and you throw a quiz in my face I’m probably going to turn and run.
Sadly, they probably make WAY too much money from this type of trading activity to do anything about it (LOUD SIGH). It would probably need to be forced onto retail brokerages by a regulator or some other form government intervention.
As for the whole r/wallstreetbets movement? I don’t think that’s going away anytime soon. The floodgates have opened, and with free trading and free social media platforms, coordinated collectives of traders will always have the ability to move small stocks. Even billionaires are allowed to pump whatever they want apparently. If they can do it, why can’t some trader with a few thousand dollars and a forum of followers? I see it on Twitter all the time.
But remember, not investment advice.
I think I’ll leave the larger societal questions to others smarter than me to discuss (Like this one).
I will say this though: This is another outlet people are using to tell us they’re hurting.
So go help somebody.
Thanks for reading.