Investing

Did Robinhooders Expose a Fatal Flaw in High-Frequency Trading With GameStop?

zoom-zoom / Getty Images

The stock market’s meteoric rise despite COVID-19 has more people getting interested in trading. It hasn’t been hard for many new traders to make a couple bucks since last April, at the height of the pandemic, and many are now considering themselves experts. Playing in a bull market propelled by the Federal Reserve is one thing, but some of these traders may in fact be the new experts.

The economy crashed between late-February to April as a result of pandemic-prompted shutdowns. However, this did provide a good entry point for many new investors. Also with more time spent at home, there has been ample time for many to acquaint themselves with the stock market as a means of making some cash on the side.

One of the main vehicles for investment has been Robinhood, a trading app that boasts a user base of over 13 million, according to the New York Times. Although this is one of a few trading platforms that new investors have chosen, it provides an interesting trading perspective, as the name would suggest.

Legend paints Robin Hood as one who takes from the rich and gives to the poor, and that seems to be the sales pitch for this app as well. However, in recent years this trading platform has been marred by accusations of potentially gouging its clients. After Monday’s trading session this idea may be put to rest.

The company that services Robinhood trades, Citadel, is known as a high-frequency trading (HFT) firm. Such firms look to earn the bid-ask spread (the difference between what the buyer and seller are asking) by making a set of high-frequency trades. Many people have taken issue with Citadel in the past for what some consider to be underhanded trading practices.

Note that, about a month ago, Robinhood settled charges with the SEC with regards to misleading its investors.

So there has been a debate surrounding this for a while. Robinhood offers zero-commission trades and was one of the very first platforms to do so, but in the process, the firm ran its order flow through HFT firms like Citadel. In short, there are some advantages and disadvantages to this.

Only recently did the SEC order find that one of Robinhood’s selling points to customers was that trading was “commission free,” but due in large part to its unusually high payment for order flow rates, Robinhood customers’ orders were executed at prices that were inferior to other brokers’ prices. Even further, the order found that Robinhood provided inferior trade prices that in aggregate deprived customers of $34.1 million, even after taking into account the savings from not paying a commission between the years of 2015 to 2018.

Here’s where the little guy fought back. Many traders on the Robinhood platform often take risky positions, and many are looking to play options as a way to get rich quick, as opposed to more traditional investing or trading methods.

There’s a whole community around this that celebrates wins, laughs at losses and shares memes on Reddit. They’re known as r/WallStreetBets. You can find many of these guys on Twitter sharing memes or the latest stock tips, some even trolling. It’s hard to take any one person seriously in this community because, at the end of the day, they’re only avatars on Twitter or Reddit. Regardless, the force is real.


The actions taken by this community by and large are risky, and most investors wouldn’t have the tolerance to make many of these bets. Buying naked options or “yolo-ing” a single stock are standard practice. But with high risk comes high reward.

GameStop Corp. (NYSE: GME), among others, was the subject of this on Monday. The stock hit as high as about $136 in premarket trading after running about 245% year to date (the last 14 trading days). It was an $11 stock in November, jumped to $19 to close December, and it closed Monday at nearly $76. Shares hit an all-time high of $159.18 at one point on Monday before retreating.

So how did they do it? A few factors in play forced this move. First, GameStop is a notoriously shorted stock. For its December 31, 2020, settlement date, 71.2 million shares were short and about 69.8 million shares were outstanding. This provided the stage for an incredible short squeeze.

Outside of this, and besides buying shares, many of these Robinhooders chose to buy the underlying options for the stock. They were mainly buying GameStop call options. For an understanding of how options work check out Investopedia’s explanation.

The key thing to note here is that buying options through Robinhood’s platform would necessitate that there be a seller as well. Market makers seemed to be more than happy to sell these options to the Robinhooders.

One more thing to know when selling options is that one should not be left naked, and the trading algorithm accounted for that by buying the required GameStop shares in case the options were exercised. However, this created a feedback loop that Robinhooders ultimately took advantage of.

As more options were purchased as the stock rose, there were more shares to cover, leading to the buying frenzy we saw on Monday. The feedback loop of buying options and then buying more shares to cover and then buying more options went round and round on Monday. By the end of the day, many got out of the trade, leaving GameStop stock up only 20%.


The question that many analysts posed over the course of the day is how a bunch of traders on Reddit could do this, by just ganging up on a stock or two. There may be other questions regarding market manipulation, but it’s up for debate.

Citron Research, a famous short-selling firm, may have been hit the worst by this. The firm actually released a statement via Twitter on Friday that it would stop commenting on GameStop, citing the actions of “an angry mob,” and I think we know who those guys are.

Be on the lookout for their next move, but don’t be tricked by any “get rich quick” schemes. There’s a way to trade the volume without risking everything.

Want to Retire Early? Start Here (Sponsor)

Want retirement to come a few years earlier than you’d planned? Or are you ready to retire now, but want an extra set of eyes on your finances?

Now you can speak with up to 3 financial experts in your area for FREE. By simply clicking here you can begin to match with financial professionals who can help you build your plan to retire early. And the best part? The first conversation with them is free.

Click here to match with up to 3 financial pros who would be excited to help you make financial decisions.

 

Have questions about retirement or personal finance? Email us at [email protected]!

By emailing your questions to 24/7 Wall St., you agree to have them published anonymously on 247wallst.com.

By submitting your story, you understand and agree that we may use your story, or versions of it, in all media and platforms, including via third parties.

Thank you for reading! Have some feedback for us?
Contact the 24/7 Wall St. editorial team.