RobinHood vs. Wall Street Key Terms

High-level explanation of terms related to stock-market action between Reddit's wallstreetbets and GME (Citron Research, Melvin Capital). Includes an overview of RobinHood's pricing models and their role in all this.

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RobinHood vs. Wall Street Key Terms

High-level explanation of terms related to stock-market action between Reddit's wallstreetbets and GME (Citron Research, Melvin Capital). Includes an overview of RobinHood's pricing models and their role in all this.

finance, investing, GME, AMC, RobinHood, stocks, news, wallstreetbets

Short Selling: A way to bet against a company’s stock price. The mechanism is complicated, but understanding some of the detail is important for this conversation.

The investor who thinks the stock price will go down borrows many hundreds or thousands of shares from an investor who thinks it will go up, and they sell it to a third investor who also thinks the stock price will go up.

The short seller now has a bunch of cash from the sale to the third investor. However, the short seller now owes the stock to the person they borrowed it from, and they are obligated to return it at some point in the future.

Furthermore, they must pay interest on this stock they have borrowed, and (this is the part that’s important) they must also maintain 50% cash collateral on the current market value of the borrowed stock.

This is the part that WSB attacks using call options. If the investor cannot pay this requirement (this is sometimes called a margin call) they must close out the trade and take the loss- even if they are right about the stock being no good in the long term, they are forced to lose by this margin requirement.

This “engineered price increase” is called a short squeeze, and traditionally, they don’t work- but this isn’t a traditional short squeeze.

Call Options: A call option is an option to buy 100 shares of stock. It is much cheaper to buy a call option than 100 shares of stock, but it is much riskier because call options expire whereas stock does not.

The amount of leverage that can be achieved using a call option is practically unlimited, because the shorter the amount of time is before the call expires, the cheaper it will be.

Buying these “Short Dated” call options is one of the riskiest, most leveraged stock trades that can be made, and a bunch of players buying them at the same time can overload the system.

Now, a further degree of understanding will help here as well. A buyer of a call does not simply win if the stock price rises. They actually are entitled to buy 100 shares of stock from the person who sold them the option, and now is where the sellers come in. This is the hard part of options.

Options are not just bought by investors, they are also sold by them. The investors who sell options are usually sophisticated and highly capitalized institutions. An investor can make much more money selling options than they can through normal means like interest or dividends, but there is significantly more risk.

Sellers of calls are obligated to deliver shares of stock to the buyers if the stock goes up. This exposes them to unlimited risk, so they usually protect themselves by buying a percentage of the underlying shares, this is called a ratio write. So this means every time somebody from WSB buys a call, an institutional investor goes out and buys 40-60 shares of the underlying stock.

Now you start to see it- if everybody on WSB buys call options on the same stock at the same time, it will trigger a bigger landslide further on down the pipe as the people selling them the options buy shares to protect themselves. This causes the share price to go up much more than the buying power of the WSB investors especially if the options were particularly short-dated.

The share price increasing triggers margin calls on the short sellers of the stock, creating the short squeeze. Timing in particular is key- and WSB allows investors to time their investments precisely to inflict the maximum amount of damage to the system. This element is, at least in my opinion, what makes WSB powerful enough to threaten wall street.

Manipulation: It is against the law to tell lies to move stock prices, and any form of this is typically illegal. However, it is NOT illegal to tell TRUTHS about stocks to move prices. It is actually encouraged! it is hard to say that there is anything manipulative about the WSB investing. They are, for starters, not being dishonest, if there is anything they are guilty of its hyper honesty- taking the very wrong-headed “Let’s Save our beloved Gamestop, so buy short dated call options on the stock!” to the max.

Further reducing the chance of manipulation being a factor is that politically, WSB is very popular. Liberals, Trumpers and libertarians alike rushed to embrace the idea of the mighty everyman, through the democratic power of the free market dunking on the cozy wall street elites.

What about Robin Hood itself, and Citadel? Front Running is a manipulation scheme where a broker reacts to customers orders before entering them. Like all manipulation, it is arguable what constitutes a lie and what is honest, especially if the actor involved is not the broker entering the trade.

Bid/Ask Spread: Not super on topic, but just worth mentioning that Robinhood may not charge commissions,but that does not mean trading with them is free. We are accustomed to only seeing one stock price. That is not, however, the price you would pay when buying, or the price you would receive when selling.

In reality, there are two prices. The lower Bid Price is the price an investor receives when selling, and the higher Ask Price is the price they pay when buying. The difference between these two numbers is the spread. The spread is very small for stocks, but it is much larger for riskier assets- particularly options & cryptos.

The price you are shown on stock tickers is usually a midpoint between the bid and ask.

I might be wrong, but I am of the opinion that RH does not make this very clear on their interface, and to this date I have not figured out how to see it, but the more trading that happens, the more money the people on the other side of this (institutional investors called market makers) profit.

RobinHood vs. Wall Street Key Terms
Info
Tags Finance, Investing, GME, AMC, RobinHood, Stocks, News, Wallstreetbets
Type Google Doc
Published 14/07/2021, 07:57:31

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