There are three things to remember as you watch the chaos unfolding with GameStop’s stock price. First, Wall Street is just what happens when you mix money with feelings. Second, the internet is real life. And third, the Street always wins, especially if you’re trading with Robinhood.
If you haven’t been paying attention, GameStop’s stock has been soaring in a remarkably volatile fashion; on January 22nd, GameStop zoomed upward 69 percent (nice) before it triggered a circuit breaker halt. The following Monday, January 25th, GameStop trading was halted nine times.
On the surface, this doesn’t make sense. GameStop, founded a year before Blockbuster, is part of a dwindling cohort of IRL businesses that are being starved by online marketplaces. These days, you can just buy video games over the internet instead of going to a soul-killing strip mall in Iowa City to buy a physical copy of the game. GameStop’s business has been suffering as a result.
Currently, many people are at home and bored, and consequently, interest in day trading has shot through the roof. There is a Reddit forum for this, r/WallStreetBets, which describes itself as being “like 4chan found a Bloomberg Terminal.” A year ago, a user called delaneydi argued that GameStop was underpriced by the market. For a while, the idea that r/WallStreetBets would take over GameStop was a joke — but then it turned serious, Bloomberg reported. The idea was to punish short-sellers, and for the little guys to pummel Wall Street.
If you think GameStop will fail and the stock will go down, or even that the company will go bankrupt, there’s a way to make money on that. Typically, this is done by short selling — a practice where you borrow shares for a fee and sell them for (ideally) a high price, then buy them back at (ideally) a lower price to return them. This can make you a lot of money, especially if the company goes bankrupt and you don’t have to return the stock!
The thing about short selling, though, is that you lose money if the stock goes up, and your losses are potentially infinite if the stock keeps going up. There are several other bad things that can also happen, such as an increase in fees or the original investor wanting their stock back. This means some shorts will be forced to “cover,” or buy the stock back at a high price, which sends the price even higher.
Right now, more people are betting against GameStop than betting it will succeed. “Short interest is 71.2 million shares, while GameStop has only 69.7 million shares outstanding,” Matt Levine of Bloomberg points out. Some people will notice that kind of thing and think, Hm, this stock is prime for a short squeeze! Basically, because so many people are short, it may be possible to trigger a chain reaction where you buy enough stock to send the price up, forcing some shorts to cover, sending the price up further, forcing more shorts to cover, and so on.
For retail investors, this process has gotten easier and cheaper because of apps such as Robinhood. In addition to letting you buy and sell stock, you can easily buy an option for stock, instead of the stock itself. If you are feeling confident in a stock, you can buy a call option — which lets you buy a stock at a specific price on a specific date.
Let’s say my fake investing firm wants to buy a call option on Company X. Currently, shares of Company X are trading at $10. I feel confident in Company X, so I buy options that let me buy 100 shares of Company X stock for $25 a share on March 1st. This contract is usually cheaper than the share price.
So let’s say Company X goes on an epic run in February, and by February 15th, it’s up to $50 a share. I can sell my options for more than I paid for them, if I want. Or I can continue to hold onto them until March 1st, when I take delivery of the 100 shares, which are now trading at $55 a share, and immediately sell them. As a result, I make a profit of $30 per share, minus whatever fees I paid for the options.
On the other hand, maybe I bet badly and Company X only gets up to $20. In that case, my losses are limited to whatever fees I paid for my options — I just never buy the shares. This makes options a riskier bet than just buying Company X stock directly, because I might just lose all the money I spent on the options, instead of at least getting to own the stock. But it means there’s a lot more upside as well, because I didn’t have to spend all the money on the stock upfront. If risk is your idea of fun, options are great!
Now, someone has to be on the other end of my trade. The outfit that sold me the options is going to try to reduce the risk that my options will hurt them, and they will do this by buying stock in Company X. That makes the stock go up, and the further up the stock goes, the more stock my counterparty will have to buy.
Options were once a fairly sophisticated thing to trade — something ordinary people didn’t really do. But Robinhood makes the option trades easy and free. Plus, there’s a social aspect to the trades — which is where r/WallStreetBets come in. Stocks are memes now, and you trade them to show off to your friends.
Day traders, such as the ones on r/WallStreetBets, are typically held in contempt by professional traders, and they are acutely aware of this. The professional short-sellers who created the possibility of a short squeeze underestimated the day traders’ sophistication, and r/WallStreetBets pounced. Time to troll Wall Street out of a fuckload of money!
The fine people of r/WallStreetBets decided GameStop was undervalued, and the stock would go up, so they put up a bunch of posts about how they were buying GameStop options. This drove up the stock price for GameStop, as their counterparties had to load up on stock to balance, and then more stock as more people bought options and so on. The soaring stock meant some shorts had to cover, sending the stock up further. As of January 26th, short-sellers have been trolled out of about $5 billion in 2021, just from their GameStop positions alone.
What does Robinhood have to do with this? Well, it makes options trading much more accessible to retail investors — but there’s something else. Trades on Robinhood are free! But Robinhood isn’t offering free trades to be nice; the company gets paid by some big-time investors such as Citadel Securities to see what retail investors are doing. This phenomenon, which other brokerages are engaged in as well, is called payment for order flow. Citadel Securities makes its money on these orders by “automatically taking the other side of the order, then returning to the market to flip the trade. It pockets the difference between the price to buy and sell, known as the spread,” according to the Financial Times.
The argument in favor of this practice is, essentially, retail investors get better prices than they would on the open market, Bloomberg’s Levine writes. The practice is controversial, though, because some critics say it harms investors. It’s theoretically possible to “‘front run’ orders by, for example, jumping ahead of a customer’s stock purchase to buy it themselves, making a small gain if the share price increases,” the Financial Times explains. “There is no suggestion that Citadel Securities engages in such activity, which is prohibited by SEC.”
Robinhood got in trouble with the SEC for “misleading statements and omissions” about how it made its money by selling the orders its traders made to other firms. According to the SEC, Robinhood investors got second-rate prices, which cost them a collective $34.1 million. The company paid a $65 million fine in December to settle charges, and the practices the SEC objected to “do not reflect Robinhood today,” Dan Gallagher, the brokerage’s chief legal officer, told Business Insider.
When asked for comment, Robinhood referred to an op-ed published by Vlad Tenev, the company’s CEO and co-founder. The company says its customers are mostly “buy and hold” investors, not reckless ones. The op-ed said nothing about payment for order flow, and Robinhood declined to comment on the practice in a follow-up email.
Citadel Securities is winning on this, though! Last June, the company was responsible for 40 percent of shares traded by retail investors, the Financial Times wrote, citing Piper Sandler. It doesn’t just get Robinhood’s orders either — TD Ameritrade and Charles Schwab also work with Citadel Securities. “Not only are retail market makers getting increased trading volume, they are likely getting increased profitability per trade,” Tyler Gellasch, executive director of Healthy Markets Association, told the FT.
Which means that Wall Street can also get in on screwing Wall Street. And it’s not just Citadel Securities. I’d be very surprised if high-frequency trading algorithms weren’t also getting in on the fun. Plus, Chamath Palihapitiya, the Silicon Valley SPAC icon, has decided to yolo along with the Redditors. (“Yolo” as a verb appears to be part of the r/WallStreetBets peculiar parlance.) Elon Musk, a man who notoriously hates short-sellers, is also observing the chaos.
At least one Wall Street firm has taken heavy losses — Melvin Capital Management, which was shorting GameStop, among other bets. It’s been bailed out by Citadel, which, confusingly, is not the same thing as Citadel Securities. (Citadel is a hedge fund, not a market maker.) Both firms were founded by the same guy, though: Ken Griffin. And by bailing out Melvin, Griffin got “a rare opportunity to invest in a talented manager on the cheap,” according to Bloomberg.
What does this have to do with GameStop itself? Absolutely nothing — this is a weird game now. And the market’s frothy, too; in July, I joined Robinhood to see how it works. The Verge’s ethics policy forbids us from directly trading stock in companies we cover, so for research purposes I picked six stocks that belong to companies I don’t cover because their earnings were next on the calendar. (I actually don’t know what several of them do.) I am a buy-and-hold investor because I am a bore, but as of today I’m a bore who’s up 30 percent. One more time: I know nothing about these companies except that I won’t have to write about them. It’s easy to feel like a genius in a bull market, and a lot of first-time day traders are probably very bullish on their investing sense right now.
At this point you may be wondering whether what r/WallStreetBets is doing is illegal — after all, it’s a group of people trying to artificially drive up a stock price in order to sell for outsized profits. And the answer is: well, maybe? It definitely seems like a pump-and-dump scheme, but — this part is crucial — no one’s lying, as Bloomberg’s Levine points out. Theoretically, the SEC could chase down the r/WallStreetBets investors, since no one’s really anonymous on the internet, but this seems like a lot of effort for what is not actually a slam-dunk case. It is “an enforcement nightmare,” James Cox, a professor at Duke University School of Law, tells Bloomberg.
Also, GameStop’s shorts seem undeterred — as some older shorts are getting out of the market, they’re being replaced by new ones. Perhaps this is because they are anticipating the “dump” portion of the pump-and-dump scheme; perhaps this is because they’re awaiting quarterly earnings, which usually tanks GameStop’s stock. Maybe they’re just having fun, too!
But: it’s not just GameStop anymore. r/WallStreetBets is yoloing its way into electric carmaker Nio, OG tech company Blackberry, and AMC, the movie theater chain. And if those day traders are doing it, then the market makers that buy the order flow from Robinhood are yoloing along for the ride. And one thing is clear: what Citadel Securities is doing is legal.
So what happens next? I don’t know — but I suspect that someone on Wall Street will find a way to make money on it.