In the last two weeks, there have been a handful of low-priced stocks that have made explosive moves up and down during the trading day (9:30 AM to 4 PM Eastern) and after 4 PM, which is called “after-hours market trading”.
The stocks typically involved, have a share price under $10 and the stock prices have been trending down for an extended period. Some large financial institutions, often hedge funds, have been shorting these stocks to make money from this.
What is Short Selling?
Short Selling is when:
- Financial companies or hedge funds borrow shares, usually from a large brokerage company
- Then they sell the shares – but they must replace them
- They have a limited time to buy the shares back
- They make a profit if they can buy back the stock during this window at a lower price
- They can lose money if the price goes higher
Firms that make money by short selling are sometimes unpopular because they are making money from the hardship of companies that are struggling when their stock price has been declining. Is this legal? Yes.
How Does Short Selling Move the Markets?
Larger investors and small retail investors have been using online bulletin boards and chat rooms, such as Reddit, to find stocks to target. They are looking for stocks that are low-priced and are being heavily shorted. Popular targets the last few weeks include GameStop (GME) and AMC Entertainment (AMC).
If enough investors start buying these stocks, it can drive the price up. As the price of the stock goes up, the short selling companies lose money if they must buy the stock back at a higher price. The combination of the new stock buyers, plus the short sellers having to buy the stock, can cause a large move up in the stock. This is called a short-squeeze and has resulted in large swings up and down in this small group of stocks.
Who Profits From the Recent Market Volatility?
Interesting that these large financial firms and hedge funds started complaining to regulators that the retail investors were causing them to lose money. We find it ironic that the hedge funds that have made money from the misfortune of declining businesses are losing money from actions partly caused by smaller retail investors.
Robinhood is a relatively new brokerage company that is used by retail investors, especially younger investors. Many of the Robinhood investors were participating in buying these low-priced stocks. Robinhood has made it free to trade stocks for people using their platform.
If Robinhood is not charging for trading, how do they make their money? Robinhood makes their money by something called “payment for order flow”1. How this works is Robinhood sends their trade orders through companies called “Market Makers”. These are companies like Citadel Securities and Virtu that have to pay a small fee back to companies like Robinhood.
Why do these Market Makers pay to have trading orders routed through them? It is so they can place their buy and sell orders before the orders they receive from brokers like Robinhood. Is this legal? Yes.
Robinhood CEO, Vlad Tenev, announced last week that they had to halt the trading of some of these stocks saying it way, "in order to protect the firm and protect our customers"3. When Tenet said he wanted to "protect our customers" -- did he mean the Market Makers or retail investors? It is unclear -- as Robinhood later resumed trading these stocks, but in limited quantities. This left retail investors unhappy and many in the media questioning if this limiting of trading was appropriate.
At Financial Journey Partners, we use Fidelity to do our trading for client accounts. Fidelity places trade orders directly with the stock exchanges to try and get the best price available on trades. Fidelity does NOT use “pay for order flow” like Robinhood and some other brokerage companies.
Could Stimulus Checks be Stimulating Retail Trading?
Another interesting point to note is that a large amount of $1,200 stimulus checks were distributed by the federal government in May 2020 upon which we saw a spike in new accounts opened by retail traders.2 Next, there was a spike in some low-priced travel and leisure stocks in June. About a month ago the federal government started distributing $600 stimulus checks and now we are seeing this unusual behavior in the stock market. Is this a coincidence? We’ll let you decide.
The politicians in Washington are working on another round of stimulus checks. Will there be more unusual behavior in the stock market after this next round of stimulus?
See what our readers thought in our one question survey results on this topic.
OUR ONE QUESTION SURVEY RESULTS!
We asked you what you thought the primary force was behind the recent market volatility in low-priced stocks was such as GameStop and AMC.
Here are the survey results:
5% - Retail investors using bulletin boards such as Reddit
5% - Large financial firms that heavily short low-priced stock
0% - Federal government giving stimulus money to people that put it in trading accounts and they buy these low-priced stocks
11% - Brokerage trading companies like Robinhood that make trading free and enable this kind of behavior
68% - All the above
11% - Not sure
Clearly most folks felt there were multiple factors that contributed to this wild and unusual trading activity for this small group of low-priced stocks.
Our thanks to all who participated!
Successful Long-Term Investment
In summary, this is the kind of high-risk behavior that can accompany short-term trading. To make note -- this is not what we consider investing as we build portfolios for our clients composed of sound companies that we think will be successful in the future.
As always – if there is anything you would like to discuss in this regard or other investments, please feel free to reach out.
1 CNBC – Here’s how Robinhood is raking in record cash on customer trades — despite making it free
2 CNBC – Young investors pile into stocks, seeing ‘generational-buying moment’ instead of risk
3 Yahoo Finance – Robinhood CEO On Trading Halts: 'We Made The Correct Decision'