Robinhood, GameStop, & the Future of Trading

Amateur daytraders on smartphone apps are driving hedge funds crazy, and pundits are saying we are at a cultural turning point for investors. GameStop, stock symbol GME, is a brick and mortar video game store that has underperformed for years. Last summer it was valued at $4 a share. On Wednesday, January 27th it closed at $347. They aren’t selling more products, and their future does not look bright, so what happened?

The rise in GameStop (and other) underperforming companies is due to a cultural shift in investing. Amateur investors, called retail investors by market pros, have been coordinating and acting together using websites like Reddit. The r/wallstreetbets subreddit has a lot to do with the meteoric rise of GameStop.

The mystery deepened on Thursday, January 28th when the Robinhood stock selling app suspended the ability to purchase GME shares but would still let you sell. Retail investors primarily use Robinhood to make their trades, and this action made them furious.

This is a story that is going to be used in future textbooks for economics, business, and stock trading. Keep reading to uncover the long and short of GameStop, Reddit, and the brave new world of online investing.

Selling Stocks Short, Long, and the Short Squeeze

When you buy and sell stocks, you can also place bets on how you think the stock will perform in the future. If you think it’s going to do well, you can promise to buy shares of the stock in the future at the price it is being offered today. This is called buying long.

If you think it will do poorly, you can sell it today and promise to buy it back in the future. If all goes well, it will be at a lower price and you will make a profit. You have to pay a fee to sell short or buy long, but if the stock moves in your direction you can make a lot of money.

When a stock is being shorted by a lot of people, savvy investors can engage in what is called a short squeeze. Short positions require people to buy the stock in the future. If there are a lot of short positions, this means there will be a surge in buying. Savvy investors can sometimes take advantage of this knowledge by betting against the short-sellers.

If enough people buy the stock and it goes up, the people who bought short positions will lose money when they have to buy. The short term demand will push the stock price artificially higher, allowing the short squeeze investors to make a lot of money. This has been routinely practiced by hedge funds and stockbrokers for decades and is considered a legal practice.

GameStop and Robinhood Investors

Retail traders are accusing the Robinhood app of acting more like the Sheriff of Nottingham. The story begins in August of 2020 when GameStop was trading at about $4 a share. By January 12th, 2021, the price was up almost 400% in four months and trading at $20 a share. The hedge funds did not believe the stock could sustain that price, so they shorted the stock.

Charles Payne from Fox business said that so many short contracts had been sold that it totaled 140% of GameStop stock.

Investors on the r/wallstreetbets subreddit noticed the abnormally large number of shorts. Some Redditors suggested buying GameStop in a short squeeze, and the idea took off. Because the idea had no clear leader and no centralized organization, it was a unique move in the culture of online trading. The small investors began buying shares of GameStop.

The price doubled in two days, going from $20 to $40 a share. Over the last 16 days, the price has gone as high as $468 a share. Hedge funds had to cover their short positions and have lost more than $5 billion to date, and Melvin Capital lost close to $3 billion. On January 27th, Robinhood decided to halt the purchase of new GameStop shares.

Stephanie Ruhle explains the platforms may have stopped trading because they wouldn’t be able to cover their positions. AOC and other politicians are outraged and are demanding more regulation of wall street and investment houses. Regardless of why they acted, investors believe the Robinhood app came to the rescue of the hedge funds, halting the ability to buy GameStop but allowing investors to sell.

The price crashed to a low of $126 and closed the day at $193.

Class Action Lawsuits

When it comes to Wall Street, the system favors entrenched interests, and retail investors claim to be operating at an unfair disadvantage. Users of mobile trading apps want to be able to make choices based on their own risk tolerance, rather than being told how to invest their money. Robinhood has been hit with a class-action lawsuit in New York on Jan 27th related to its actions:

“On or about January 27, 2021 Robinhood, in order to slow the growth of GME deprived their customers of the ability to use their service, abruptly, purposefully, willfully, and knowingly pulled GME from their app,”

– Plaintiffs

“In sum, Robinhood has completely blocked retailer investors from purchasing GME for no legitimate reason, thereby depriving retailer investors from the benefits of Robinhood’s services,”

– Plaintiffs

Richart Gatz filed a similar suit in Chicago. His suit claims “The value of these options decreased by almost two-hundred percent.”

Robinhood CEO Vlad Tenev said they have processes to respond to volatility like raising margin requirements. “We always remain focused that the system remain reliable”.

Billionaire investor Lee Cooperman told CNBC that the small investor would likely get hurt by the short squeezes. He said short term profits could turn into massive losses when the short squeeze ends. Cooperman claims the Fed is to blame for creating an environment that made the GameStop short squeeze possible. He said it would “end in tears,” for the public.

The Future of Investing

There is bipartisan anger in Congress condemning the actions of Robinhood and the hedge funds. It remains to be seen if retail investors using smartphone apps will be able to buy and sell as they wish. No matter what happens, people who are more experienced with stock trading are more likely to come out ahead. Inexperienced retail traders using mobile apps are taking huge risks and could lose their entire investment.

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