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Get Shorty! A New Era of Retail Trader “Rebellions”?

The Retail Trader “Rebellion” of January ’21 was, in itself, a short-lived affair. The concern that it would send the markets into a chaotic downward spiral that would extend through February proved false. The only residue left of the meteoric rise of stocks like Gamestop (GME) and AMC is their mildly elevated trading levels from three weeks ago. The fall of the upstart stocks, engineered from the top down, was as precipitous as their rise, coordinated via social media from the bottom up. Now that the supposed Main Street vs. Wall Street Super Bowl is over (Wall Street won, though some individual traders scored big), we might wonder whether this is the first “rebellion” of many, and whether there will be other fields of battle. It’s time for a post-game analysis.

Image Credit: Wikimedia Commons
Image Credit: Wikimedia Commons
Image Credit: Wikimedia Commons

Tweeting “Gamestonk!” to his 40 million Twitter followers on January 26th, Elon Musk added fuel to the fire that WallStreetBets Redditors had already lit to burn down the hedge funds shorting Gamestop (GME). Two days later, Musk followed up with “Here come the shorty apologists. Give them no respect. Get Shorty!” Amusing novel and movie references aside, there’s no love lost between Musk and short sellers. Tesla may be the world’s most valuable auto maker today, but Musk struggled to stem losses for a long time. He took to Twitter in those years, attacking those who bet against his company. These tweets often catalyzed a jump in the Tesla stock price that inflicted financial damage on the Tesla bears.

Elon Musk – Image Credit: Wikimedia Commons

When news of the retail trader “rebellion” broke, I couldn’t resist getting in on a bit of the action. It’s one of my trading strategies to look for stocks with a high short float in a volatility squeeze, the Bollinger Bands compressed inside the Keltner Channels, ready for a release of buying energy. I’d just made a nice option trade like that with Blink Charging Co. (BLNK) on January 25th, a move that, in retrospect, might have been an early rumble of the runaway train driven by the WallStreetBets Redditors.

By the time I heard about the action in GME and AMC, however, the hedge fund managers had started to squeal. As a consequence, Robinhood, TD Ameritrade, and other online brokerages were limiting the ability of retail investors to buy shares or call options on stocks that were heavily shorted by the Wall Street hedge funds, leaving the hedge funds to do what they needed to do to protect themselves.

One of the reasons they did this is that it wasn’t just a short squeeze that was driving prices up rapidly, the effect was compounded by a gamma squeeze as short sellers bought out-of-the-money calls to hedge their short positions and other traders, hoping the meteoric rise would continue, also bought out-of-the-money calls hoping to profit from them, and all this forced the market makers selling these calls to buy more shares of the underlying stock to hedge their positions, thus further driving up the price. This snowballed so quickly that Melvin Capital, which was massively short on GME, wound up having to be bailed out by Citadel Securities and Point72 Asset Management to the tune of $2.75 billion. Too bad, so sad.

Image Credit: ThinkorSwim Trading Platform

Despite deeply troubling prejudicial treatment of retail traders by the brokerages, resourceful traders managed to find other stocks with high short floats, and these started to get attention as access to GME, AMC, and other stocks got restricted. I saw this happening and decided to get involved in a small way.

Being careful and circumspect, I was able to pull some money out of an overnight option trade taking advantage of a runup in a stock with a high short float (SKT), then later capitalize on the expected pullback in the markets as hedge funds sold off other holdings to cover their short losses. I shorted Amazon (AMZN) and the SPY ETF with low-risk out-of-the-money bear call spreads the next day, kept the vertical spreads overnight, and bought them back at a much lower price the following day, pocketing a good portion of the premium. Small potatoes, but nice just the same. Some traders, however, made a lot of money; others, needless to say, lost their shirts. It was all good sport while it lasted. Consequences and questions linger, though, and a couple of these have particular importance.

Did Hedge Funds and Brokers Collude?

The first question is whether online brokers like Robinhood were right to restrict the ability of retail traders to purchase shares and options in stocks with a high short float while hedge funds were free to trade those same stocks without restrictions. Many retail traders think the brokerages were in bed with the hedge funds and, just when Main Street was getting the upper hand on Wall Street, the brokerages shut down retail trading to protect their cronies. It’s not an unreasonable view. Some conspiracies are real, no matter how much the conspirators deny it.

Image Credit: Wikimedia Commons

Let’s start with the suspicious details. The founder of Melvin Capital, Gabriel Plotkin, who graduated from my doctoral alma mater, Northwestern University, started his career in 2001 at Ken Griffin’s Citadel Securities before moving to Steve Cohen’s SAC Capital. He left SAC in 2014 to found Melvin Capital after he was implicated by the SEC in an insider-trading scandal. After the scandal, Steve Cohen moved his investment operations from SAC Capital to Point72 Asset Management.

When the world came crashing down on Melvin Capital recently because of the short bets it had that went awry, most notably GME, who should turn up to bail out Plotkin but Griffin and Cohen? As it turns out, Citadel also had a substantial short position in GME. In the bailout deal, Citadel and Point72 are receiving non-controlling revenue shares in Melvin Capital that will eventually expire. Griffin and Cohen ostensibly believe this worth doing because Melvin Capital had been one of the most profitable hedge funds on Wall Street prior to the debacle, and they both have confidence in Plotkin’s skills as an investor. Sounds good to me. What do you think?

Image Credit: Wikimedia Commons

Meanwhile, Citadel has a more than cozy relationship with the online brokerage, Robinhood, since it pays to handle more than 50% of Robinhood’s order flow as well as paying for order flows from nine other brokerages. Robinhood sells its order flow, receiving payments that vary depending on the type of security, the underlying price, and the time of order placement, among other things. Citadel is one of Robinhood’s best customers, so it pays for Robinhood to keep Ken Griffin happy. He was not happy with the retail trader rebellion. Draw your own conclusions.

Ken Griffin, CEO and CIO of Citadel
Image Credit: Wikimedia Commons

The other interesting and somewhat appalling thing is that Robinhood has been selling its customers’ orders to high frequency trading firms like Citadel for over ten times the amount of other brokers engaging in this same practice. Why? Robinhood can offer free trade executions to its customers because it is not offering them the best execution for their trades, something it has a fiduciary responsibility to do. Instead, the opportunity for best execution is given to the high frequency trading (HFT) firms like Citadel who are running hedge funds and processing the orders to their advantage as they look over everyone’s shoulder. If you’re not paying for the product, you are the product.

Citadel was fined 22 million dollars by the SEC for violations of securities laws in 2017. Two other HFT firms to which Robinhood directs is orders, Two Sigma Securities and Wolverine Securities, have also been investigated. Two Sigma has been in trouble with the New York attorney general’s office and Wolverine has paid a $1 million fine to the SEC for insider trading. This whole story was broken by Logan Kane over at Seeking Alpha back in 2018, after which Robinhood became the focus of an SEC investigation. Rather than admitting guilt, Robinhood settled out of court, paying a fine of $65 million to the SEC. Of course, this money all lands in the government’s pocket, not the pockets of Robinhood’s customers, who paid for it through poor execution of their trades.

Image Credit: Wikimedia Commons

The bottom line of this story is that there was substantial opportunity for collusion among Melvin Capital, Citadel, Point72, and Robinhood, all of whom are very chummy and sometimes rather shady actors. I’m not saying this is what happened, but it does look, act, and quack like a duck (if you know what I mean).

Beyond this, if you’re looking for a brokerage that refuses to sell their orders to HFT firms, you might consider Vanguard, which has refused to do so, or Interactive Brokers (IBKR), which is one of the preferred brokers among knowledgeable retail traders, and which doesn’t sell order flow but rather lets their customers route their orders to any exchange they please.

This is not to say that every broker selling order flow is bad. I use TD Ameritrade and their ThinkorSwim trading platform. I’ve been mostly satisfied, though I was annoyed that they, like Robinhood, shut down retail trading while the hedge funds salvaged their positions. And who buys order flow from TD Ameritrade? Citadel, of course. It’s important to know the reality of what you’re getting into. Tastyworks is another brokerage that specializes in options and offers very fast execution of trades, though it’s not very user friendly for those just starting to get their feet wet, and it too sells order flow.

Were Brokers Negligent?

Of course, Robinhood has a different story to tell. It maintains that it had to restrict trading until it could increase its collateral with the Depository Trust and Clearing Corporation (DTCC). This also happened at other brokerages. The interesting fact is that it wasn’t all trading that was restricted, but rather trading through retail brokerages. Any hedge fund could do what it needed to do to save its (ass)ets, however, because it operates through prime brokers, not retail brokers.

If the playing field were level, everyone’s trading would have been restricted until the retail brokers could post collateral. But the big boys have their own field and can play anytime they want. Still, there are some regulations that govern the behavior of all brokers, so let’s talk about them.

When traders buy and sell stocks, the trades don’t settle immediately. Here in the United States, trades take two days to settle, which means that brokerages incur some risk while waiting to disburse or receive cash payment. The National Securities Clearing Corporation (NSCC) handles this cash settlement for securities and the rules for the brokers are set by the Depository Trust and Clearing Corporation (DTCC). Both the Dodd-Frank legislation and the DTCC require brokers to post clearing deposits to reduce the credit risk in case brokerages fail to produce the cash for settlement.

When trading volume spikes, brokerages like Robinhood assume higher credit risk and are required to post higher deposits, but they may not have enough cash on hand to do so. For somewhat complicated reasons, especially with high volatility, buying securities increases the amount required in the clearing deposits by the DTCC, while selling them decreases it (see the references below). This is why Robinhood disabled buys but not sells for its retail traders. What this means, then, is that Robinhood was required to post a clearing deposit it did not have and, in order to prevent having to post an even larger deposit, it halted retail buying until it could raise another $1 billion in cash.

Image Credit:
Wikimedia Commons

Should Robinhood have had this cash on hand? Was it their responsibility to be prepared for such an eventuality? Were they negligent? The bottom line is that you can’t be prepared for everything, and while there were definite signs that short squeezes and gamma squeezes were imminent, it would have been very hard to predict just how large the move was going to be.

To some extent, then, it may be that Robinhood can say it was just following regulations. On the other hand, one must also realize who Robinhood’s customers really are. The retail traders are not their customers. The retail traders are the product that Robinhood sells to the HFT firms.

Retail traders can trade stocks and options for free on the Robinhood platform, but they’re not getting the best prices on their trades. This doesn’t mean they can’t still make money, but they’re making less than they would and losing more than they would if they actually got best execution, which, undoubtedly, is Robinhood’s responsibility. That’s why they paid a $65 million fine to the SEC. But it hasn’t changed their behavior and it hasn’t put any stolen money back into the pockets of retail traders. So there’s irony in the company name, for unlike its namesake, who returned what the rich had stolen to the poor, the Robinhood brokerage takes advantage of the poor to make the rich richer.

 “Yellen” New Regulations Over the Roofs of the World?

Enter the regulators, who thrive on controlling what everybody else does. Perhaps the most amusing opening sally was from the former Clinton-era SEC commissioner, Laura Unger, who compared the Reddit-driven trading frenzy to the crowds that overran the Capitol on January 6th, painting them all as dangerous extremists intent on inflicting financial harm, along the way suggesting that the Capitol crowds wanted to inflict physical harm.

Unger thinks regulators should step in to prevent such financial activity “the same way that…social media platforms took down the former President’s Twitter account…. The FCC does have the authority to suspend trading… they could suspend trading and find out… whether there is a concerted effort to manipulate the market.” She also thinks the SEC might have the responsibility to monitor and regulate chat in financial forums like the subreddit WallStreetBets. Stay in line, peasants, and don’t try to game a system that’s stacked against you!

Image Credit: Wikimedia Commons

Interestingly, the Feds may not yet be monitoring, let alone regulating chatter in online financial forums, but hedge funds have started to monitor this chatter, and the intensity of their data mining just increased. They don’t want to be blind-sided again. For example, Thinknum, a web-scraping data provider, is building a Reddit-specific dataset in response to a huge spike in client demand. The tool will track ticker mentions on a variety of subreddits including, of course, WallStreetBets.

But what are the Feds going to do? The official Treasury Department statement reports that the meeting the Treasury Secretary, Janet Yellen, had on February 4th with the heads of the SEC, Commodity Futures Trading Commission, Federal Reserve Board, and Federal Reserve Bank of New York, was convened in part to review the issue of volatility in meme stocks and the response of brokers to it to determine whether everything that has happened is “consistent with investor protection and fair and efficient markets.” In an interview with Good Morning America, Yellen remarked that “we really need to make sure that our financial markets are functioning properly, efficiently and that investors are protected,” by which, of course, she means retail investors.

This is concerning because retail investors really don’t need the kind of “protection” to which they would likely be subjected. In this regard, Congresswoman Maxine Waters, who hasn’t always had the best ideas but has still managed to become the Chair of the Financial Services Committee, has promised to hold a hearing that focuses “on short selling, online trading platforms, gamification and their systemic impact on our capital markets and retail investors.”

The problem here is that everything Waters lists as a matter of concern is a good thing. In particular, short selling sends clear signals that a company’s stock is overvalued. Furthermore, it is the only way that investors can save themselves, mitigate losses, and even continue to profit when markets are moving downward or sideways. It is a necessary tool.

Most importantly, the very things that Waters is talking about investigating have contributed to the democratization of the markets, opening them up to everyone. Some retail investors and traders fare well and others do poorly, but the ability to manage your own accounts and to invest and trade online has opened a new door of financial freedom for average citizens. We don’t need or want “protections” that would inhibit our ability to manage our own financial affairs, thank you very much.

Janet Yellin, Secretary of the Treasury
Image Credit: Wikimedia Commons

The other concern, of course, is just who will be the beneficiaries of such “protections,” especially since Treasury Secretary Yellen had to seek a waiver from ethics lawyers because of a conflict of interest before she convened last week’s meeting. Her tax returns reveal that she has earned over $7 million in speaking fees from Wall Street banks, influential investment houses, and large corporations, including Citibank, Barclays, City National Bank, Credit Suisse, UBS, Goldman Sachs, Google, Salesforce, and (surprise, surprise) about $810,000 from Citadel. Recusal would seem to be in order in the matter of evaluating the propriety of Citadel’s actions in the GME Reddit affair, but Yellen has chosen to move forward.

While Yellen has been critical of financial bad actors on Wall Street, and Democrats point to her record of enforcement of financial laws with Wells Fargo when she was at the Federal Reserve, initial indications from last week’s meeting of regulators are that the Feds will attempt to go after individual traders seeking to game the system in ways harmful to the hedge fund crowd, not take on the hedge funds, brokers, and HFT firms who have rigged the system in ways that harm individual traders.

As evidence of this, the Justice Department’s fraud division and the U.S. Attorney General’s office are collecting information about the coordination of trading from the brokerages and social media platforms that were used to catalyze the meteoric rise of stocks like GME and AMC, and the Commodity Futures Trading Commission is investigating whether misconduct was committed by Reddit traders targeting silver futures.

Image Credit: Wikimedia Commons

Meanwhile, no official mention has yet been made of investigation into the glaring conflict of interest instantiated in firms like Citadel, which function as both hedge funds and order flow processors for retail brokerages. Although the divisions in such companies are ostensibly separate, it’s clear that retail traders are not getting best execution and that the HFT algorithms managing hedge funds are taking both precedence over and advantage of retail trade traffic channeled to them from brokerages like Robinhood. This has to stop. Furthermore, payment from HFT firms to brokerages for order flow also needs to be stopped, even if this means that fees need to be reinstituted or raised a bit for the trades that retail traders place through their brokerages. There’s a reason these firms are willing to pay for order flow, and its not a happy one when the interests of retail traders are taken into account.

The upshot of the situation is that the priority of the regulators already appears to be slanted away from abuses by hedge funds, brokerages, and HFT firms, and toward turning their regulatory guns on the little guys. This hardly seems fair when all the little guys are trying to do is coordinate their actions to compete more efficiently against a system that is running sophisticated trading algorithms at lightning speed on multi-million dollar dedicated computers in the service of large financial firms–especially when the system is further rigged so these firms can look over the shoulders of these retail traders and process their trades with delays and at prices that favor the performance of their own hedge funds.

Convince me all this stuff isn’t happening. Someone, despite an obvious conflict of interest, should be “yellen” this (hint, hint) with a barbaric yawp from the roofs of the world.

The “Rebel” Yell: Getting a Mellow Portfolio High from Pot Stocks (Before Crashing)

Meanwhile, back on the subreddit ranch, the WallStreetBets crowd was pushing pot stocks higher the week of February 8th, hoping to lasso profits with a hemp rope. In a strategy that mimicked what they did with GME and AMC, the Redditors took note of the most shorted pot stocks, names like Tilray (TLRY) with a short float of 46.25%, Aurora Cannabis Inc. (ACB) with a short float of 20.74%, and Cronos Group Inc. (CRON) with a short float of 14.95%, and tried to coordinate buying activity that would juice the stock in hopes of a short squeeze and maybe even a gamma squeeze.

As a result, Tilray closed at $67, up 51% on Wednesday (02/10/21), peaked in the mid-$70 range in after-hours trading, then headed down in pre-market trading on Thursday, gapping down to the mid-$50 range on open, then declining the rest of the day back to the low-$30s. It closed at $29 dollars to end the week, still up about a third from where it began the month. ACB and CRON behaved similarly, with less pronounced double-digit gains on Wednesday, falling back to mildly elevated levels by the end of the week.

Some traders undoubtedly profited from this. Others got burned. I know a professional option trader who does really well (he made over $18 million last year) who thought he smelled a gamma squeeze in TLRY and bought a thousand shares at $59 per share on Wednesday afternoon. He made $8,000 by the close, rode it even higher after hours, then had it gap down badly Thursday morning. He got out around noon for a loss of $21,000. This guy trades million dollar accounts, so it was a small percentage portfolio loss for him, entirely within his risk parameters–he knows what he’s doing and how to manage his losses–but his weed still got smoked on the trade.

Image Credit: ThinkorSwim Trading Platform

Should less experienced traders attempt to trade this kind of volatility and uncertainty when even experienced traders sometimes get smoked? The fact remains that some will and it is their prerogative to do so. If you’re seeing clear signals that a stock is in a short squeeze and it’s started to take off like a rocket, if you want to get in on the action, then my advice to you would be to use stop losses and, if you’re able to do so, monitor the trade regularly throughout the day. Don’t be greedy. Take profits after you’ve made some money. Not making all the money that could have been made is far better than losing money. Your equity curve is still moving from the bottom left to the upper right, so be happy.

If you’re thinking about holding the trade overnight in this kind of situation, don’t. You can’t tell what the stock is going to do in after-hours or pre-market trading, and it may gap down badly the following morning and not recover. So if the end of the trading day is approaching and you’ve got some profit, get out! And if the end of the day is approaching and you didn’t use a stop loss or you had one and you didn’t respect it and now your account is down, get out! Don’t hang on overnight hoping against hope that tomorrow will smile on you. At this point, it’s more likely to crap on you. There’s no point turning what could have been a smaller loss into a bigger one.

When it comes to a stock that’s undergoing a short squeeze or a gamma squeeze, the one thing that’s certain is that it will be overvalued on its meteoric rise, and it’s going sell off sooner rather than later. Short selling will eventually win, even if the original short sellers got flushed out in the squeeze. You’ve put blood, sweat, and tears into making a profit in the market, so don’t get flushed out yourself as the stock plummets. Just remember that what goes up, must come down (spinning wheel, got to go round):

When All is Said and Done

Is this going to be a new era of retail trader “rebellions,” then, where everyone is looking for stocks with high short floats and trying to instigate a squeeze by organizing traders on social media? Calling it an “era” is too grandiose. It’s a trend and it’s likely to be short-lived. Three things militate against it being an ongoing strategy and we’ve already touched on all three of them. The first is that, regardless of what the Feds do, Wall Street isn’t going to get caught snoozing again. Fool me once, shame on you; fool me twice, shame on me. They’ve already started to data mine chatter on financial forums and, if they get wind of an organized effort to take advantage of a short float, they will vacate or hedge their positions appropriately to control the consequences.

Secondly, preliminary indications are that the first priority of the regulatory agencies will be the attempt to shut down efforts to coordinate, through online financial forums, large-scale collective action among individual traders for the purpose of producing a specific market outcome. Large hedge funds have the potential to manipulate the markets this way because of the size of the positions they can adopt, but the regulators don’t want individual traders to organize in an attempt to achieve this power collectively. So it’s doubtful, after putting down the peasants, that the regulators will go on to address the inequities produced by payment for order flow, or address the issue of the same financial firms both running hedge funds and processing order flow.

Financial regulators in positions of power are too beholden to the financial giants and too involved in that world themselves to do anything but cultivate the appearance of propriety by distancing themselves in legal terms and public perception from these interests while they hold their regulatory positions. But you’d better believe that they plan to go right back to that world once their time as regulators has ended, and they want to protect the relationships they have there.

Finally, there’s the experience of the individual trader. Aside from now being afraid that they’ll be singled out and made an example of by regulatory prosecutors, the fact is that, given the number of traders that have to participate to achieve the effects of a short squeeze or a gamma squeeze, it’s certain that most of them don’t really know what they’re doing beyond trying to buy low and sell high. Without a clear understanding of the volatility of the situation and some safeguards and hedges in place, chances are many of these traders are getting burned. You know the phrase: once burned, twice shy. After an experience in which they lost money, a significant number may decide the risks are not worth it. And the more would-be traders who decide that manufactured short squeezes are not worth the risk, the harder it will be to organize the collective action needed to produce them.

In short (pun intended), the “rebellion,” if that’s what this is, doesn’t really have long-term prospects. But all hail the short squeeze! And remember: let’s be careful out there!