Greater Volume. More Volatility. Less Time.
Risk Matters.
The last few weeks highlighted the need to bring a new understanding of, and strategy for, investment risk. Volatility is increasing and occurring over a significantly compressed timeframe – for individual stocks and the overall market. Recent trading activity in GameStop, AMC, and a few other stocks demand an investment strategy focusing on Risk Adjusted Return.
The new power of retail investors is here to stay, and that will shake up traditional portfolio managers because they are increasingly losing control of the trading process.
A Trading Floor in My Pocket.
Trading apps on platforms like Robinhood and social media chat rooms found on Reddit are game changers, fueling an unprecedented level of interest and activity (social media information is easily accessible and trading activity has very little friction – few, if any fees, and immediate). These two factors are irreversibly changing the market.
In the past year, U.S. brokers added at least 10 million new retail trading accounts, and a shift to zero trading commissions late in 2019 unlocked a wave of activity that dwarfed even the wild days of the dot-com bubble. Beginning in early 2020, and coinciding with coronavirus lockdowns, trading activity started to surge and has not subsided, even as the economy has gradually reopened. Average daily trading at the biggest retail brokers hit a record of 6.6 million a day in December 2020. In January 2021, it reached 8.1 million. On January 27, 2021, equity volume was triple the average day in 2019.
Retail investing has been a small fish trading in the large hedge fund and institutional pond. But that’s changing. Before the pandemic, retail trading made up about 15% of equity volume; now, it’s consistently making up more than 20%. The game changer is when that activity is concentrated on just a few stocks, a much more likely event among retail investors (driven by social media platforms), and it makes a substantial difference. In the case of GameStop and several other highly shorted stocks, it can cause startling price movements in a very short time.
Small Investment, Big Return – What Can Go Wrong?
Daily options trading has more than doubled since 2019, led by retail investors on platforms like Robinhood (with no fees). As of January 2021, small buyers account for about twice as much of the options volume as the big and midsize players. This is a disruptive and sustainable change. The retail option buyer does not seem to understand the true risk involved. While the upside can be much greater than the downside if the option investment works out, there is the risk of losing all invested capital. This fundamental misunderstanding of the true risk assumed by this investment strategy combined with the market discontinuity relative to historical option trading, magnifies risk as “groupthink” dominates movement in and out of these investments, exacerbating price movements and creating a vicious cycle of increasing volatility occurring within a compressed timeframe.
In many ways, options are a leveraged side bet on a stock. But they can also have an enormous impact on the underlying stock itself. Market makers who execute options trades have to hedge by buying the stock itself, often in large volumes. That action can cause the stock to rise even more.
In 2020, smaller retail investors comprised over 10% of all bullish contracts in the US, compared to approximately 5% among institutional investors and hedge funds.
Groups of traders have targeted single stocks before, but never with the velocity and enthusiasm that they embraced with GameStop and other stocks.
About Those Harmless Institutional Short Sellers.
Short sellers have been targeted with a combination of focus and hatred, and social media is fanning those flames. It seems any publicly traded equity with a large short position can be targeted easily, bringing substantial volume and price pressure against the short sellers. There is systematic targeting of highly shorted stocks. When this happens, Wall Street blinks, and short positions are covered quickly in spite of significant losses – simply to avoid further losses. But, continued closing out of short positions drives prices further upward. Institutional short sellers get crushed.
While there are cries to stop this trend and somehow regulate it, that’s most likely impossible. A seismic shift has changed the game.
Extreme and Compressed – I’m Looking at You, 2008 Financial Crisis.
Volatility will continue to be more extreme over a more compressed timeframe. This meta-trend requires revisiting risk calculations for any portfolio. Value at Risk (or VAR) is a reasonable tool to assess a portfolio’s risk in more normal trading environments. When the market operates at extreme edges, these calculations fail spectacularly (as in the 2008 financial crisis). Ask anyone at Melvin Capital…
There Must Be Something Wrong, Right?
It is not illegal if a large number of investors have the same opinion about a stock and drive it to ridiculous levels. It is illegal if someone infused social media discussions with misinformation in order to manipulate the market. But finding manipulation in a boisterous online forum is challenging to the point where it probably will not be an issue.
The Roller Coaster.
Stocks with high short interest have made big moves in January 2021. Here are the 15 stocks with the heaviest short interest.
| Company / Ticker | Recent Price | Short Interest as % of Float | YTD Price Change |
| GameStop / GME | $325.00 | 121.1% | 1,625% |
| fuboTV / FUBO | 42.25 | 71.9 | 51 |
| Ligand Pharmaceuticals / LGND | 185.35 | 64.9 | 86 |
| PubMatic / PUBM | 39.75 | 63.3 | 42 |
| Bed Bath & Beyond / BBBY | 35.33 | 63.0 | 99 |
| National Beverage / FIZZ | 151.54 | 62.6 | 78 |
| Alberton Acquisition / ALAC | 12.83 | 62.1 | 12 |
| AMC Networks / AMCX | 49.42 | 57.9 | 38 |
| SunPower / SPWR | 54.01 | 57.5 | 111 |
| Macerich / MAC | 15.70 | 56.9 | 47 |
| Tanger Factory Outlet Centers / SKT | 15.43 | 52.4 | 55 |
| Tootsie Roll Industries / TR | 39.58 | 45.9 | 33 |
| Accelerate Diagnostics / AXDX | 10.26 | 44.9 | 35 |
| Academy Sports and Outdoors / ASO | 21.50 | 44.8 | 4 |
| BigCommerce Holdings / BIGC | 79.94 | 44.6 | 25 |
Note: Short interest as of Jan. 15
Sources: Dow Jones Market Data; Bloomberg
The fastest and biggest impact appears to be on short sellers. Losing an estimated $5 billion on a single stock tends to change behavior. Large short-sellers’ practice of announcing short calls to much fanfare is over, and it’s unlikely any fund will be quite hesitant to “talk up their book” publicly again. Institutional short sellers will have to be both quieter and more careful. Being short stocks with 150% short interest is probably a thing of the past.
About Those Regulators – A Little Frenzy Bothering You?
Regulators will now probably try to impose new guardrails around retail trading. The SEC said last year that it was looking closer at options trading and how brokers disclose risks. Trading on margin could be curtailed, and the rules for getting into options may change.
Brokers will undoubtedly need to make changes, too. Their apps and websites have already been under pressure from a surge of retail trading. Several had to curb trading last week in some stocks for regulatory and financial reasons, angering customers. Ultimately, the brokers facilitated a frenzy they couldn’t keep up with. Now, they will have to adapt or watch their clients disappear. Robinhood, in particular, has much to prove (the company wants to go public this year).
Hedge funds – even those that don’t regularly go short – will also have to adjust. Much as they use alternative data to track credit card receipts and get ahead of earnings reports, they’ll now have to watch the message boards. Data companies are ramping up web-crawling specifically to track Reddit. The great innovation of 2021 seems to be a robot sifting through emojis for investment signals.
You Say You Want a Revolution.
No, the retail revolution is clearly not going away, even if some market participants may hope it does. Those in on the fun should expect new margin limits with their brokers and possibly more stringent requirements for complex trading strategies. For everyone else, the message is more complicated. Buy-and-hold investors need to be aware of the trends, but if they need a new strategy, it is unclear. Short-term price volatility may wash out over time, generating stable long-term returns anyway. But it is naïve to think that there have not been seismic shifts.
The Madness of Crowds.
The “crowd-squeeze,” causing the GameStop move has already shown the potential to be a systemic risk to broader markets, particularly when pricey markets are looking for an excuse to correct. A small number of investments can ignite a market firestorm. The myth of “non-correlated assets” should probably be dispelled permanently.
Government action to protect against the fallout of volatile trading is uncertain and most likely to be ineffective. Investors need to develop new models beyond quarterly earnings reports and must factor in unrealistic optimistic expectations that cycle through the markets with much more regularity – taking some stocks to dizzying and seemingly irrational heights. But, as John Maynard Keynes said, “markets will stay irrational longer than you can stay liquid.”
So, is this a tug-of-war between tradition and the future? Do hedge fund managers live in the past and continue to look down upon the retail investor as insignificant? Perhaps there is a pervasive belief that retail investors don’t know anything about finances or the market (which may be true). But that is likely irrelevant.
Value is Not Price.
Economic theory teaches us that the value of any security is the present value of future cash flows, discounted at a reasonable interest rate. But price is determined by supply and demand. What is very clear in the securities market is that demand has increased substantially while supply has remained mostly constant. The resulting impact on prices is an economic outcome that even retail investors understand.
Is This the Future?
One thing is clear, investment strategies that do not factor this new understanding into investment portfolios will be a thing of the past.
