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How flows before the pros are disrupting the stock markets

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1. How did it all start?

Online brokerage Robinhood Markets Inc. and other app-based platforms have introduced a new wave of home traders to the market, raising concerns about the gamification of investing. New accounts surged early last year after a move by brokerage giant Charles Schwab Corp. eliminate industry-induced fees, just as the coronavirus pandemic has left many people stranded in their homes. These traders from r / wallstreetbets – the Reddit forum dedicated to making money and having fun doing it – are turning to exploiting a financial system that is seen to have locked them down for years. Much to the horror of the financial establishment, r / wallstreetbets then found a way to capitalize on this system and bend it to its own will.

More and more. In August last year, retail traders accounted for a fifth of stock volume in the US, double the share of a decade ago and behind only market makers and high-frequency traders at 43, 5%, according to Bloomberg Intelligence. The retail segment is now larger than quantitative investors (15.9%), hedge funds (9%), traditional long participants only (6.4%) and bank affiliated traders (5 , 8%).

3. How are they changing the way markets work?

Traditional value investing involved finding an undervalued company and buying stocks when they were relatively cheap, in the hope that they would appreciate. For retail traders, it is not clear if value matters a lot. Some of the stocks targeted are seen as far removed from profitability and the kind of fundamentals that would normally attract investors. Yet once a chosen action is launched and the price starts to rise, it attracts even more attention and flows out of the r / wallstreetbets crowd. One way to think about this is that the prices were self-limiting. Stocks would rise to a point where valuations (earnings multiples or book prices) would become unattractive, causing stocks to fall and giving valuations a chance to normalize. These days, prices can be much higher than traditional security analysis suggests.

Feed before the pros is one way of putting it. The simple premise here is that in an environment where flows matter more than fundamentals, people who trade stocks in their basements might be better equipped to judge where the money is going next. For example, they may have a better idea of ​​the strength of a particular stock story, or a better idea of ​​where the forum hive spirit will go next, than the portfolio managers attached to their models. valuation. In a more than a little ironic turn of events, professionals can now chase the flow of retail.

5. Who are the pros here?

Short sellers – funds that borrow a stock and sell it, betting that the price will have fallen by the time they have to buy it to return it – have become the target. These companies would typically unveil a new position with great fanfare, expecting to cast a cloud over the company’s stock. This year’s scrum on GameStop – in which retail traders clashed with short-selling firm Citron Research – suggests that this could become a thing of the past, and in fact, Lemons Andrew Left announced on January 29 that the company will no longer publish research on short selling. A hedge fund or short seller announcing a bet against a stock could now be the equivalent of waving a red flag at r / wallstreetbets herd of bulls: a signal to load call options and force a move higher. Predators have become prey.

People at r / wallstreetbets often target stocks where they see an opportunity to exploit a structural weakness in the markets. For example, some have been outspoken about buying stock options in an attempt to drive up stock prices. (Options are contracts that give the holder the right to buy or sell the underlying security at a predetermined price after a set period of time; commission-free applications such as Robinhood have made options trading much better. The idea is that buying a ton of options forces the market makers – the intermediaries of the transaction – to hedge their own exposure by buying the shares of the underlying company. This momentum may be enough to drive a stock’s target price higher, which can then trigger more call buys in a frantic feedback loop: the stock rises, short sellers give up, they buy stocks for. return them, and their purchases drive up the action. After.

7. Can the little ones really outweigh the whales of Wall Street?

The thing to look at here is not the amount of money that retail investors spend, but the amount of leverage incorporated into that spending. Here is a scenario:

Bob has a Robinhood account. He bought a single weekly call option contract of $ 3,250 on Amazon stock on August 14 for $ 1,500. This option happens thanks to a market maker – call her Jenn – sitting in a large brokerage bank. But Jenn doesn’t take the other side of Bobs’ business, rather she aims to be a neutral facilitator. Her job is to make deals, not bet on them, so she wants to hedge her position. She does this by buying Amazon shares, performing a calculation based on what’s called the delta of her position. The delta is the change in the option’s value depending on the price of the underlying stock. In this case, she judges that she must buy $ 66,100 of Amazon stock to achieve neutrality. If Amazon’s stock goes up, she may have to pay on the Bobs option, but at least that will be offset by the gain on her Amazon stock.

A few days later, Amazon’s stock is indeed increasing, increasing by 5%, so Jenn has to rebalance her books in order to keep her neutral position. This time, as the delta of her position has increased, she has to buy even more shares. In fact, she has to buy $ 230,000 of Amazon shares. Bobs, a minimal expense of $ 1,500, turned into a $ 230,000 stock purchase.

By targeting dealer exposure in a concerted fashion, some retail traders are actually trying to take advantage of a phenomenon known as gamma squeeze – betting that as the value of Amazon stock nears a strike price of options, dealers will need to buy more and more of the underlying stock.

8. What about hedge fund shorts?

Gamma pressures can be more effective when combined with a short press on a company’s stock. Traders on r / wallstreetbets have often identified companies with a lot of short interest and a limited number of stocks available for trading. This makes it more difficult when short sellers have to scramble to buy back stocks and close their positions. This kind of momentum also helps drive the price of a stock up, fueling the loop. Hedge fund Melvin Capital revealed on Jan. 25 that it had accepted a $ 2.75 billion injection from rivals Citadel and Point72 Asset Management after short positions left it with large losses. Business assets fell to around $ 8 billion in January after starting the year with $ 12.5 billion.

It would be tempting to dismiss all of the above as a game if it didn’t really move stocks and impact real companies. Shares of GameStop, a video game retailer, have surged exponentially this year – even catching the attention of Elon Musk, whose steep rise in shares has made him the richest person in the world this year. The message boards were full of suggestions on what GameStop could actually do with this very real money before the stock crumbled. So at some point these random flows start to impact fundamentals as well. AMC Entertainment Holdings, another stock meme, avoided bankruptcy in late January by capitalizing on a stock rally fueled largely by retail traders. Some hedge funds may sell some of the more bullish stocks to cover losses, which would hurt performance.

10. So, what slowed the peak of Gamestops?

Robinhood halted trading in some memes, including GameStop, triggering a massive outcry from retail investors (and some politicians) who saw the move as a way to limit GameStops’ astonishing rally and to protect hedge funds. . So why are they doing this? Robinhood CEO Vlad Tenev said in written testimony at a Congressional hearing on Feb. 18 that the brokerage must respond to requests from the Depository Trust & Clearing Corp., which is the main chamber of clearing the US stock markets. Settlement of stock trades takes two days in the US and in the meantime the brokerage is on the job. Clearing houses require brokerage firms to collect collateral – part of the value of a transaction – to cover this risk. As purchase orders poured in, Robinhood found itself hanging on to many warranties, straining its finances. In response, he reduced his line of credit and restricted the purchase of certain stocks. He then listed the stock purchase and option contract limits for 23 companies, including GameStop and AMC. Tenev called false the conspiracy theories Robinhood coordinated with Citadel to restrict retail investors. Ken Griffin, the founder of the Citadels billionaire, said in his prepared remarks that we had no role in Robinhood’s decision to limit trading in GameStop or any other stock even. The clearing and guarantee requirements were put in place as part of the Dodd-Frank regulatory reform aimed at reducing systemic risk in the markets. They are, somewhat ironically, supposed to protect investors.

11. What are regulators saying?

For the United States Securities and Exchange Commission, tackling online comments that hypes stocks are an uphill struggle, mainly because it is difficult to prove that these posts are part of an illicit scheme to manipulate the market. A man who helped fuel the massive GameStop surge, Keith Gill, the Redditor and YouTuber who has become a symbol of the indictment against GameStop, has been sued for alleged securities fraud – a charge he denied in his written testimony at the congressional hearing, which was called to examine the memes frenzy and whether new rules are needed. In December, Massachusetts regulators filed a lawsuit against Robinhood, alleging it had aggressively marketed its platform to novice investors and failed to put in place controls to protect them. In the meantime, Conor Sen, founder of Peachtree Creek Investments and Bloomberg opinion columnist, argued that dealers might need to start pricing options differently to compensate for this behavior.

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