GameStop: Reddit’s retail traders had a secret ally
A foreword from the founder, Tim Sunderland
A couple of weeks back, I was approached by a chap from Durham University who was keen to take part in an internship here at Mitto Markets – so I obliged. It only turns out here’s got a keen eye for stocks and was lucky enough to have two professors do a lecture on the whole GameStop fiasco! So who better to gives us all a debrief on what exactly what happened! The floor is yours Rhys!
We have come to the end of arguably the most interesting saga of the capital markets since the Flash Crash of 2010, where a lone wolf retail trader caused a trillion dollar market crash in minutes. GameStop, a classic brick and mortar video game outlet, has been subject to one of the most extravagant financial experiments, or protests, with retail traders showing their might for the first time. But did they have a secret ally?
A Reddit page called “WallStreetBets” orchestrated a financial protest against what was at the time, the most shorted company in the Russell 3000 with institutional investor and hedge fund positions amounting to over 120% of shares in the company according to Factset data, granting it a financial death wish. Here, the percentage is calculated using the number of shares sold short over the previous two weeks compared to the total share float from the end of the previous month.
A look at the financials of GameStop shows a poor position, with net profit and total revenue decreasing year on year since 2018, it’s hard to argue against the miserable trajectory of GameStop, even without the damaging effects of the pandemic. The more convenient, but costly, video game digital downloads were becoming increasingly popular amongst users with Sony reporting more than half of its played games were sold digitally in 2020. The industry has also seen the introduction of video game “streaming” and cloud gaming where players stream real time game play from offsite high-end systems they pay for on a subscription basis.
However, a select few found a chance of recovery for GME.
Michael Burry, the eagle-eyed hedge fund manager who was the first to identify the US real estate bubble of 2008 three years prior, saw promise in GameStop. He recognised the brick-and-mortar stores still were free cash flow positive and could see further increases post-pandemic considering the next generation of video consoles were still reliant on physical discs.
“With the short squeeze in full effect during the last week of January, GME share price soared by over 23 times within 11 trading days in a spectacular display of retail trader might”.
Ryan Cohen, the co-founder of industry leading online pet store “chewy”, also went long on GME with a 9% stake. He noticed the significant improvements to the leadership team, which other investors argue was a contributing factor towards the poor performance of the company in recent years.
One Reddit user in particular, DFV also bought into this potential upside back in June 2020 with a long position of $50,000. Publishing industry standard due diligence reports on the Reddit forum, DFV inspired others to go long, with the underlying purpose of facilitating a large scale short squeeze on the hedge funds who have sent the Reddit users teenager-years favourite store to death row.
As the price of GME stock rises, the hedge funds with short positions have to purchase additional shares as collateral to maintain their position, a market function that can form a dangerous positive feedback loop and place the hedge funds with the largest short positions in difficult waters.
The Reddit forum has been misrepresented as a bunch of “dumb money” retail traders where their collective agreement to buy shares is their only weapon.
The truth is quite different, a thorough look into the users of the forum, especially in the early days of 2019 shows members to include some High Net Worth individuals and ex-industry professionals.
The forum is home to a surprising level of market knowledge, premium trading ideas and complex strategies that give professional hedge funds a run for their money. All under the disguise of clueless amateurs as shown for example with forum measuring system for number of members being counted in “degenerates”.
Starting as an app that simply measured price movements, RobinHood became the first zero-commission free trading platform aiming to democratise investment for the average retail trader who was used to pricey commissions and clunky software.
It is important to note how RobinHood makes over 60% of its revenue from selling its limit order flow to third party hedge funds, mainly HFT funds and quant funds to execute on their behalf, a process called Payment for Order Flow.
A delve into RobinHood’s terms and conditions openly reveals this system. A retail trader using the platform can post either a market order or limit order, the former executes the position at the requested volume but at whatever the going market rate is, for example buying 100 shares of GME at market rate will take 100 shares out of the limit order book at the lowest ask price going. However, the reality is when a retail trader presses the buy order, even if it is a market order, Robinhood transforms your order into a limit style order with a 5% upper and lower price limit and adds this to the order flow passed on to the hedge funds to clear. However, sell orders aren’t subject to this transformation and remain as untouched market orders.
RobinHood has come under investigation for its decision to freeze the buy side for its most volatile listed shares, of course GME being top of that pile. Many have framed this as a manoeuvre to prevent the layman gaining benefit from the previously inaccessible capital markets with puppet masters passing orders down from Wall street and political stakeholders. In reality, it is simply financial and not political.
RobinHood, facilitating payment for order flow to generate 60% of its revenue, has to pay the hedge funds a fee in proportion to the volatility of the shares it facilitates market making for. The trading platform froze buy orders because the payment fee asked by hedge funds acting as clearing houses in order to cover the volatility of GME was almost the same size, $3 billion, as the capital of the company. Hence why Robinhood froze buy side and had to raise more investment, roughly $1 billion in its first round.
Considering RobinHood’s core ethos of democratizing the capital markets with zero rate brokerage fees, the only way they were able to provide this was through the payment for order flow mechanism which tightens bid/ask spread to current, or even better than, market price.
Hence, it is paradoxical to accuse Robinhood of preventing retail traders from gaining one up on the institutions when the actual issue that made the buy side freeze was due to the very mechanism that allows retail traders to make positions with zero fees in the first place.
With the short squeeze in full effect during the last week of January, GME share price soared by over 23 times within 11 trading days in a spectacular display of retail trader might. However, the retail traders’ damage may have been caused by a different market player. The research by Professor Julian Williams of Durham Business School into the National Market Service Standing Quotes for GME stock for the last week of January discovered something astonishing.
In the space of a few seconds, the net ask and bid quotes for GME turned majorly negative in favour of the buy side from a huge influx of buy limit orders swamping the market. With a huge amount of buy orders flooding the market, the amount of scepticism on the authenticity of the orders from the ask side was very high. This was likely due to ask order holders questioning if the huge inflow of buy limit orders were High Frequency Trading hedge funds doing flash pricing. Here, orders are published and then immediately cancelled in order to find the going market price, or alternatively legitimate orders from trading platforms. This scepticism caused a drop in the ask side volume leading to an overall striping of ask orders up the book to an extent where we witness a crossed market. Here, for only a few minutes, the fundamental rule of market clearing is broken as the bid price was greater than ask price, presenting a perfect arbitrage opportunity.
This can have a hugely damaging impact for derivative traders, like the hedge funds with large short positions using put options, because the jumping mid price of the underlying asset creates a proxy short squeeze, just like that desired by the Reddit traders.
The pending SEC investigations may shed more light on this matter, but these events lasting roughly 5 minutes and occurring on average three times a day during the last week of January 2021, arguably change the narrative of the battle.
This changes the narrative to a case of hedge funds using the firepower provided by the retail traders orders to bring competing hedge funds to their knees. Unfortunately, the protection provided by industry leading HFT systems, like that found at Citadel, allowed them to hold their ground long enough to make it through the onslaught in time for the freezing of buy orders flowing in from the trading platforms. With the time pressure threat silenced, the hedge funds could re-layer the limit orders on their books to restabilize the market and protect their downside.
Due credit is awarded to the Retail Traders for orchestrating the first market based financial protest, which could have alternatively finished as a lucrative pump-and-dump scheme, but maybe they should be more cautious in blanket labelling hedge funds as the villains of modern day capital markets when instead they should actually be offering thanks to the ones aiding their cause, even if the ulterior motives are different.
If you’ve enjoyed this article and want to start your investing journey, feel free to reach out to me personally on t.sunderland@mittomarkets.com or call +44 (0)208 159 8985
Important Notice: When investing in shares, your capital is at risk. The value of the investment and any income from it can fall as well as rise, so you may get back less than your original investment.