The Truth About Gamestop, Hedge Funds and Robinhood

Much has been said about market manipulation since the frenzy created by trading in Game Stop. AOC is calling for investigations, the SEC is saying they are looking into it, and some commentators have even said that the brokerage firms who halted trading did so at the request of the Wall Street elite. This is patently false.  There is a very good reason Robinhood and others halted trading in Game Stop and others. I have been a market participant or observer since 1986. I have traded almost anything that moves and a few things that don’t.

1.     All brokerage firms are highly regulated and must meet certain capital or liquidity requirements just like banks. Therefore, if there is a surge in trading, they may or may not have the requisite capital. Robinhood is NOT Charles Schwab! Due to the surge in trading Robinhood announced on its website that it had to raise $3.4 Billion.

2.    Brokerage firms that cater to small, inexperienced investors are far more likely to be sued when things go wrong than larger firms.  Therefore it makes perfect sense that the senior management would limit their exposure when there is a frenzied rush of speculative trading.

Here is what happened from the start. A popular website began discussing stocks that had high short interest. Short interest is the % of outstanding stock that has been sold short. Think of it like this. If I borrowed your lawnmower and sold it, I’d be short one lawnmower. If you asked for it back I would have to go buy one just like it. If I was able to buy the identical mower you would never know I sold yours. Further, if the price I paid to cover my shortage of one mower was lower than what I sold yours for, I make a profit. Short selling is that simple.

Hedge funds, at times, identify companies that they think will drop in price or go out of business. They borrow stock from their brokers and sell it. Now they are short the stock just like the lawnmower. Later they hope to buy it back at a lower price. If the stock goes up, the hedge fund loses money, the more it goes up, the worse it gets until finally, they can take it any longer. All investors have a pain tolerance and this is true of hedge funds. They cannot watch a position deteriorate indefinitely. So they have to buy back the stock to cover their short positions. When this happens a rush of money floods into the stock causing it to rise. At the same time, a group of small investors had a plan to buy Game Stop and cause it to rise simultaneously. As Game Stop rose, the funds got nervous and eventually pulled the plug. One fund in Florida lost ½ its entire value in two days! That is billions of dollars transferred from the super-rich to ordinary investors. Is that such a bad thing?

So why the attack on Robinhood? In my opinion (I have not interviewed the company), Robinhood went into risk management mode to protect itself while upsetting a lot of clients.  Nothing was stopping these investors from opening accounts elsewhere to buy Game Stop.

So are the markets manipulated, under the control of the elite? Nope. Game Stop is back to where it was before all of this started, so if it was manipulated, it is all flushed out now. Some won while others lost but the market did what it was supposed to do – it created a place where people could invest in what they wanted to.

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