Game(Stop), Set, Match: A Wall Street Love Story

March 23, 2021

Dear reader,

Today we’re pleased to bring you Jay Caauwe’s take on the GameStop short squeeze and what it means and what it doesn’t. 

Jay is my (P.J. O’Rourke’s) go-to guy for wisdom about financial markets. We’ve been friends for… gosh, I don’t even know… all of this century and a chunk of the last.

We met while he was a senior executive at the Chicago Board Options Exchange. When CBOE introduced its Volatility Index (VIX) market, I said to Jay, “You mean I can now buy and sell fear?” Jay said, “What do you think you’ve been buying and selling already?”

But it was Jay’s comment on risk itself that was the wisest thing I’ve ever heard about financial markets – and most of the rest of life.

Jay invited me to a VIX conference. He and I spent a day listening to the “quants” lecture us on the mathematical aspects of volatility. I said, “Jay, they’re talking about how to measure risk, and I don’t understand a word they’re saying.” Jay replied, “Don’t worry, PJ, if you could measure risk, it wouldn’t be risk.”  

Game(Stop), Set, Match: A Wall Street Love Story

By Jay Caauwe

It has become a bit too easy to describe the recent price dislocations and the short squeeze tumult in GameStop, AMC, Koss, and others as David taking on financial Goliaths. But it’s interesting to note, quite similar to the biblical version, this showdown was not a skirmish of chance, but one of design. It was an unmeek and not-at-all-helpless David disrupting the status quo.

But first, some backstory…

Day trading and individual investing have imploded over recent market sessions, with much of the chatter being discussed on social media platforms like Reddit. And a plethora of this short squeezing and volatility is taking place over at Robinhood, the mobile app offering commission-free access to stocks, options, and exchange-traded funds.

Much of the activity has focused on stocks no longer in grace, those that were beaten down due to corporate fundamentals or as part of an out-of-favor industry segment. Going back to 1971, it was the over-the-counter platform known as the National Association of Securities Dealers, or NASD, that first saw the introduction and uptake of day trading.

A dozen years later, NASD created the small order execution system (SOES), making it easy for individuals to execute stock trades automatically so long as the orders were for 1,000 shares or less. Trades placed through SOES bypassed the phone lines used to make most trades and placed orders in a matter of seconds instead of minutes. Some initial restrictions were implemented in terms of the frequency one may enter the market, but in essence, day trading was born.

The Securities and Exchange Commission (“SEC”) defines day trading as…

Day traders rapidly buy and sell stocks throughout the day in the hope that their stocks will continue climbing or falling in value for the seconds to minutes they own the stock, allowing them to lock in quick profits. Day trading is extremely risky and can result in substantial financial losses in a very short period of time.

So as you’d expect, the companies that have the most connectivity points to exchanges and electronic communication networks (ECNs), with cutting-edge speed and technology, rule the day. They stream orders or quotes to the various exchanges with the hope of capitalizing on small price dislocations, which, if done a great number of times, produces the desired outcome. Securities are not held for long lengths of time, and transactions are based on a pattern of change, velocity, and magnitude. Sometimes this is the “nickels in front of a steamroller” analogy… But when done specifically and timely enough, it becomes your model or strategy.

The hubbub around Robinhood comes down to how much the Reddit marauders really matter with their own unique style of day trading. Apparently, they matter enough… The House Committee on Financial Services met on February 18 for a hearing regarding recent market volatility, GameStop’s and AMC’s rally and subsequent sell-off, and the various brokerages’ roles in the chain of events. Robinhood CEO Vladimir Tenev, Reddit CEO Steve Huffman, and popular WallStreetBets member Keith Gill were ready and eager to testify.

Among the sentiments bandied about by various committee members and panel experts, they heard concerns akin to what an EU market regulator brought forth in a market analysis…

“Discussing the opportunity to buy or sell shares of an issuer does not constitute market abuse,” the EU’s top market regulator said in a statement. “However, organizing or executing coordinated strategies to trade or place orders at certain conditions and times to move a share’s price could constitute market manipulation.”

That was leveled at the Reddit community for its bulletin board obedience to ply into certain depressed stocks. But it sure seems like it should apply to professional market-making groups of the world. And at the retail level (you, me, and others that do not understand or care to understand some of the complexities of financial products), don’t we get pumped with newsletters and broker dealer house research reports that offer buy and sell signals?

Knowing that the average hedge fund is not long (see: short sellers) and that it runs a multiple of strategies within a given asset class, I would posit that hedge funds and market makers have more muscle than the “you only live once” (YOLO) crowd. A key differentiator would be what Citadel, Wolverine, Virtu – the professional market makers and proprietary trading groups – are doing is viewed as risk-mitigating investing or trading and liquidity provision, whereas the YOLOs are gambling.

And we should give credence to that. Again, day trading differs radically from investing in that it’s based on very brief movements in the price of stocks. For these very reasons, day trading is more akin to gambling than investing. But wait, aren’t these market-making groups also day trading? Yes, they are… But one needs to consider the day trades as part of a bigger strategy or portfolio picture playing out at the market making or hedge fund.

So, if these market-making groups are in the business of printing money – and if they can do it, oftentimes in concert, with other market-making shops to beat down an already depressed company – how is that any different than an online community of upstarts throwing their own caution to the wind (not hedge-fund investors’ dough) and trying to benefit from a contrary position? How is what “the Street” does and promotes any different than what occurred with what the Reddit crowd did in GME and AMC? It’s not, in my opinion. And while many market professionals may not equate it with price transparency and liquidity discovery, what takes place across Redditt and Robinhood is fairly transparent.

And then on January 28, Robinhood restricted the trading on certain Reddit stocks… on the very platform that was party to the recent price swings. This had a rather agog Twittersphere affect with levies of hedge-fund elitism and manipulation purported to help the funds being thrown about.

We do need to understand the financial onus that this entire market scenario, especially the short squeeze, could have created… which exposes a problem at the clearing house level. That comes down to the fact that the shares of the targeted short sellers exceeded the total shares outstanding of that particular firm. So as the prices moved higher, the shorts defaulted at their brokerages who needed to cover, causing further upward price movement and put the brokerages in the untenable position of defaulting at the clearing house.

Conceivably, the U.S. regulators never could have predicted this scenario, with a short squeeze applying upward pricing pressure on the very groups standing to benefit from a group of non-market fundamental upstarts.

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So what makes Robinhood popular? Well, free commissions for starters… but the large broker dealers can also claim the same economics for their clients. Its cachet comes in how it was designed for a generation of mobile platform friendlies… users that could quickly, and from the same device, load up a Spotify tune and order over Grubhub, all while trading on an uncomplicated, no-minimum-balance trading platform, specifically marketed to this demographic.

So, if Robinhood is basic compared with the traditional houses and does not charge commission, how does it make money? The usual business models for this type of enterprise are in place, from interest made by lending out investors’ idle cash much the same as your local bank does, or with premium accounts that grant a certain level of margin trading. And then there is payment for order flow (“PFOF”). According to a 2018 Bloomberg report, Robinhood makes more than 40% of its revenue from PFOF. And from its website we learn:

Robinhood sends “your orders to market makers that allow you to receive better execution quality and better prices. Additionally, the revenue we receive from these rebates helps us cover the costs of operating our business and allows us to offer you commission-free trading.”

Instead of orders being processed on a designated contract market exchange, companies like Robinhood make money by directing trades through behind-the-scenes partners that provide the other side to the trade and warehouse that position internally.

Consider this… Disney is at or about $195 per share, and you want to buy 10 shares. In these PFOF cases, the brokerage does not necessarily route your buy order to an exchange. When you tap your app to trade, a brokerage like Robinhood or any of the other online brokerages that utilize PFOF will take your order and reroute it to a market maker, which will pay the brokerage (and generally does so on a per-share basis) for the opportunity to take the other side of the order.

By design, the system allows the online brokerages to manage thousands of orders more effectively by routing them off to be executed by a market maker. Costs are kept low for the brokerage because of trade aggregation, and the market maker stands to gain due to the higher trading volume and ability to squeeze out volume-weighted edge.

Now, PFOF is not without its critics. At that very House Committee of Financial Services hearing, Rep. Alexandria Ocasio-Cortez (D-N.Y.) pointed out that in a 2016 report, the SEC found that the PFOF process created “a potential conflict of interest” with a brokerage’s duty to execute trades to the best possible standard and to maximize the payment for order flow. There has been criticism that this situation gives brokerages an incentive to increase the amount that their customers trade, even if it’s not in their best interest.

What became clearly apparent was that the Reddit marauders were not interested in what’s “in their best interests,” as they were far too busy not just bidding up GME… but leveraging up… That’s because many were using options to achieve their pay dirt. And in many cases, it was short-dated options with two weeks or less to expiration. And these options were (originally) far out-of-the-money options, which are inexpensive to buy but can skyrocket in value if the underlying stock makes a move.

To buy a share of GME stock and hope it rallies is not the same payoff as if I buy one GME out-of-the-money option, giving me the right but not the obligation to exercise it into 100 shares of GME. That folks, is when the leverage kicks in. Remember that one option purchase, put or call, gives you access to 100 shares. That’s where many of these hedge-fund slayers were profiting. As the stock went up, their low premium options, including ones bought dirt-cheap and out of the money, are now rather nicely in the money. And now you either sell it at a higher premium… or when properly margined in your account, exercise your right to acquire 100 shares of GME.

Buy a cheap one-lot option, watch it rally, exercise into the stock, and sell your 100 lot of stock that was catapulted higher during the short squeeze. “Let it all ride” was the mantra… YOLO was the reverberating theme. Pretty easy, right? Just like house flipping… except there does exist an industry adage or maxim if you prefer. And that is, the bulls make money, the bears make money, and the pigs get slaughtered. Rooting for the underdogs of the world to take on the Goliaths makes for good lessons learned and even better press. And certainly, it’s interesting sport when you look at how the marauders thump their public chests in the chat rooms.

Good, bad, or “meh” may describe the long-lasting impact and effect of this quasi discipline of trading. I only wish they were around and targeted the American Motors and National Lampoon stock that were 1987 deadweight in my account.

Jay Caauwe is a well-traveled Chicagoan that still resides within three blocks of where he was born. Before cofounding Supercritical LLC, a cannabis and hemp advisory and management solutions firm, Jay was drawn by the allure of open outcry, beginning at the Chicago Board of Trade in 1983. Working through the ranks, he became a floor trader at CME Group in 1987, trading stock index futures and options. He left the trading floor in 2004 to join the Chicago Board Options Exchange, where he oversaw the exchange’s global business development effort for the CBOE’s futures products based on the VIX Index.

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Regards,

P.J. O’Rourke
Editor in Chief, American Consequences
With Editorial Staff
March 23, 2021