Yahoo Finance Trader: Robinhood, Reddit/GameStop drama suggests Wall Street has a 'plumbing issue'
The Reddit-fueled frenzy behind GameStop’s (GME) surge last week — burning hedge fund short sellers and forcing Robinhood to curb activity in a clutch of hot stocks — illustrates a “plumbing issue” that exists in trading markets, according to one trader.
The frenetic retail trading that took place over the last several weeks, roiling global markets in the process, creates a flood that blows away traditional risk management, veteran trader Peter Borish told Yahoo Finance.
“I think it's all great, and we all love David trying to beat Goliath, but when Robinhood says you can only buy one share of GameStop, I don't think you're going to be taking on multibillion-dollar hedge funds," Borish, a strategic strategy consulting to CIBC, said in a recent phone interview.
The plumbing aspect is where it gets complicated, because options are really the only strategy where you end up having to buy in the direction of the trend, Borish added.
"If I'm short options. I'm short a call, and the price starts to go up, I have to buy GameStop as it goes up to hedge the position, the more it goes up, the more I have to buy," Borish explained. It’s a key reason behind why Robinhood was forced to restrict trades, a controversial move that unleased lawsuits and a torrent of criticism.
The winners want to get paid, so if they cash out their position, they want to get their cash. If you're a loser, you have to put up more money, Borish said.
"Well, if I don't put up that money, Robinhood has to give that money to the clearinghouse,” he explained. “And this is why they suspended [buying] because if they don't have the capital hand, which is why Robinhood had to draw down a billion dollars, then Robinhood's in trouble.”
Borish added: “The protection of the system is Robinhood has to get money from the customer and then put it up at the clearinghouse. If [the customer] doesn't have it, Robinhood has to put the money up at the clearinghouse.”
Shares of GameStop crashed more than 54% on Tuesday, but bounced by over 4% to last trade near $94. The stock had traded as high as $483 during the Reddit frenzy.
‘I gotta buy it back’
The market turmoil forced Robinhood to tap credit lines to meet deposit requirements from its clearinghouse. The app has also raised a total of $3.4 billion from investors since Jan. 29.
Borish believes Robinhood needs the pause to see if they can get the money from the people losing on the trade.
"And the irony of all these markets, of course, is as volatility goes up, you raise margins. Everybody goes, 'That makes sense,’” Borish said.
“But if I'm long, and I'm making money, and the volatility goes up, and you raise the margin, it doesn't matter because I have that in my winnings. It's the loser that has to put more money up,” he added.
“If they don't have money…they may end up having to buy the GameStop back, so that further accelerates the trend of the stock. That's why I call it partially a plumbing issue. So if I'm short a call, and all of a sudden the price goes up a bunch and I don't have the money, I gotta buy it back,” Borish said.
The trader noted that it's this complexity around options that explains why people don't talk about it much.
"I buy and sell GameStop [stock] there's one price. But if I'm short options and then they start to go up. So, I'm short a call, and the price starts to go up; I have to buy GameStop as it goes up to hedge the position. And the more it goes up, the more I have to buy,” he told Yahoo Finance.
"Unfortunately, like a real plumbing issue, you're not going to know right away until you start getting in there and looking at it or a leak springs." Peter Borish
If a stock trader is short GameStop's stock at $10 and it goes to $0, they make $10 off the trade. If you think the stock is going to $0, you might ladder sell call options at different strike prices and premiums. The further months you go out, the higher the premiums.
Yet with many strike prices over many months, this can make for an enormous number of potential trades and not enough liquidity to electronically trade options. A market-maker selling someone a call has to buy the stock to hedge that position.
But as you get closer to expiration, the more the gamma starts to kick in — causing prices to "go up dramatically," creating "these accelerating moves upon accelerating moves," Borish explained.
"Unfortunately, like a real plumbing issue, you're not going to know right away until you start getting in there and looking at it or a leak springs,” the investor told Yahoo Finance.
“So, if you've got a little leak, you go up in your ceiling, and you have to go find out where it's coming from unless, of course, it just collapses and then you're like,” he added.
Borish's view is the recent options expiration "buys a little time on the plumbing issue," but it doesn't necessarily buy time for those portfolios that need to be readjusted, especially if clients are providing 45-day notice to redeem at the end of the first quarter.
"You've got to go look for the leak. That's where I think the regulators come in. Smart market participants who know there's some stress are going to push it," Borish said, speculating that professional market players, rather than just retail investors, might also be behind the volatility.
Money mind games
In the short run, most non-fundamental, non-news-related market moves are "really the supply and demand for money," Borish explained. Looking at the history of short squeezes, "when it's all done, the stock eventually gets down to its fundamentals."
"Whether it's nine months or a year from now, it'll probably be down 90% from its peak, or more. But that doesn't do anything. So people go, 'Well, it's overvalued, so I'm going to sell it.' But the supply and demand dynamics in the short run can overwhelm them," Borish said.
Of course, this gets into the mental aspect of trading, which Borish notes is "super hard." The inflated price action — which was never sustainable — put a number of investors “on the wrong side of the trade,” he explained.
“And you're like, 'Well, I've already lost so much money. It can't go much higher.' So once you've lost your discipline and you're trading on the market's terms, instead of trading on your terms, you've lost,” Borish said.
“And that's what happened in day three of this thing when it just became a runaway train,” he added.
According to Borish, at the highest level, what happened with GameStop is a failure of risk management. That happens, and the acceleration of the craziness has to do with the characteristics of options markets and the nature of how they behave.
"It's a humbling, humbling business. And this business is worse because the mental aspect of money is so difficult,” the trader explained.
“Every person had been in that position where they've been up and then they've lost or they can't understand why and why are they out to get me? And they are,” Borish said.
However, the notion that Reddit investors were eyeing GameStop was public far before it became the market’s focus, he added.
“Are you saying all these hedge funds had no idea that that information was out there? And if they didn't, their risk management should have said, 'Hey, wait a second. The risk-reward characteristics have changed. We should do something about it,’” he added.
Julia La Roche is a correspondent for Yahoo Finance. Follow her on Twitter.