What We Can Learn From The GameStop Madness

More than a third of the companies in the S&P 500 are reporting earnings either this week or next. As a general rule, I don’t recommend positions that will be open when a company announces earnings, so that limits potential trading opportunities.

I would like to talk about how earnings look so far, or how Federal Reserve policies are affecting the stock market. But there’s a more important story unfolding in the markets right now. The saga of GameStop and Robinhood is more important than many analysts realize. (My colleague Nathan Slaughter gave his take on it in this piece.)

Why The GameStop Story Matters

This story is so important because it identified some concerns associated with market structure.

When we place trades, we send trade instructions to our brokers. It’s the broker’s job to execute the trade. Since that’s their job, we expect them to make money, but we also expect the cost to be fair. This system has worked well for hundreds of years.

Robinhood seems to explain to investors that this system isn’t fair. I say they “seem to explain” rather than simply saying “they explain” because nothing on Robinhood’s website is especially clear. One example of what I mean by that is below:

“When you buy or sell stocks, ETFs, and options through your brokerage account, your orders are sent to market makers for execution. To compete with exchanges, market makers offer rebates to brokerages. Market makers typically offer better prices than exchanges.

Robinhood Securities, our clearing broker, has relationships with a number of market makers and sends your order to the market maker among these that’s most likely to give you the best execution, based on historical performance.”

This all sounds rather benign. Yet, Robinhood makes hundreds of millions of dollars from rebates. These payments account for the majority of the firm’s revenue. And execution isn’t well-defined in this statement. It doesn’t mean you will get the best price, or even a fair price for your trade. It simply means the trade will be completed.

Grizzled market veterans like me understood Robinhood how was making money. But the “broker for the people” seemed to convince many that they were simply leveling the playing field and allowing small investors to access Wall Street for free.

I know Wall Street. Many of my friends work there. My best friends are in the industry. None of them do anything for free. Wall Street exists to make money, and Robinhood made a lot of money selling orders from small investors to Wall Street.

For years, everyone was happy. Robinhood took pennies and a few dollars from the poor and sent the money to some of the richest and most powerful players on Wall Street.

Then, a group of traders on Reddit decided to target some hedge funds. They bought GameStop to create problems for the funds, and they inadvertently created a problem for Robinhood.

As the price of GameStop rose, all brokers were notified they needed to increase margin deposits at the firm that settles trades. This is routine and it was handled routinely by most brokers. But Robinhood didn’t have the money. That’s the problem that has people on Reddit, the media, and even Congress, so upset.

A popular complaint is that Wall Street changed the rules when the little guy started making money. Nothing could be further from the truth. This was largely a problem with one firm.

Robinhood was undercapitalized. Other brokers met the margin calls without needing to seek new investments. The good news is that Wall Street’s structure worked. When volatility increased, margin calls went out.

The bad news is that ONE relatively large firm (Robinhood) had difficulty meeting the margin call. It’s likely many of its customers suffered losses because the firm was unable to meet its minimum obligations.

What We Can Learn…

One lesson we can take from this is to be sure you are doing business with a well-capitalized firm. All brokers exist to make money. When all trading costs are considered, especially with options, it’s best to be with a firm that has been tested in volatile markets.

[Related: Getting Started With Your Broker]

Another lesson is to understand your edge. Buying GameStop because everyone else is buying GameStop is probably not a good edge. An edge requires understanding where you have an advantage.

For Income Trader, our advantage is that we trade with a time-tested strategy using a unique indicator and a strong focus on risk. This strategy also relies on understanding how markets work.

We recognize there are large firms and hedge funds on the other side of our trades. In fact, often times firms like Virtu Financial and Citadel are on the other side of our trades. I designed this strategy specifically to trade with those firms and others that use their strategies. They provide our market, and we benefit from their actions by understanding how that works.

I’ll continue following the news about Robinhood and trading in stocks mentioned in Reddit. But I’ll be reading to understand how these factors affect market structure and to identify potential risks to what we do.

I don’t expect this to change what we do, but I do expect to see that other firms are undercapitalized. That could lead to a bear market, like the one we saw in 2008, and I am watching closely for signs of that.

Editor’s Note: My colleague Jim Fink also understands how the big hedge funds work. And that’s why he calls his latest report the “most important work of my investing career…”

He’s showing regular investors how to quickly and predictably multiply the gains of regular stocks. By following just a few simple steps, it allows you to take regular stock movements of 8%, 17%, or 34% and amplify them to generate profits of 100%, 300%, even 800%.

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