Viewers of the 2021 Superbowl saw a 5 second ad in which 1 of the seconds was devoted to the above screen. If you weren’t able to pause the screen you didn’t get the point until you searched the ad out on the internet and paused its video. Even seeing the screen is not enough for many to get the point. But the target audience understood. They were young social-media-savvy would-be investors with a history of video game playing. Social media company Reddit used the ad to remind them that one of its forums had caused a stratospheric rise in the price of a small videogame company called GameStop.
The story of financial bubbles is as old as money itself. People become willing to pay more and more for something merely because they think they will be able to convert their purchase back to a much larger sum of money at some later date. Those who buy early and get out before the end can become wealthy. The bubble keeps attracting new investors. There are more and more of them as the bubble’s fame grows. Then the supply of new investment money dries up and some small bit of bad news bursts the bubble. The many people who purchased just before the end lose a lot of money. Their loss enriches those few who bought early and sold before the crash.
This post is about how small and large investors played the GameStop bubble and how computer technology helped them do it.
There are two main ways of predicting the future. The easiest is to project a current trend forward. That works until there is a state change of some kind that kills the trend. More difficult is to try and understand all that is going in the present well enough that you can predict the next state change. Members of the Reddit investment forum WallStreetBets were mostly adherents of the first point of view. Hedge fund managers tend to adhere to the second.
The first technology that helped the members of WallStreetBets was the forum itself. Reddit allows anybody to set up a forum. That person becomes its moderator and is responsible for keeping posts by members on topic and within Reddit’s overall rules. If the forum grows large the founder will appoint additional moderators. By the middle of 2020 WallStreetBets had over 900,000 members and 50 moderators.
Early in 2021 those moderators got into an internecine fight that forced Reddit to step in and fire a bunch of them. But that’s another story. See reference 1.
Although WallStreetBets was created to let investors who wanted to make wild bets with disposable income, it seems to have taken on the additional role of a peer-to-peer training center for novice investors. What the newbies learned from WallStreetBets was how to jump onto a trend and ride it. As the GameStop bubble became more and more famous, more and more novices joined WallStreetBets, by 2021 it had over 8 million members.
So this is one of the newer aspects of internet technology. It is possible now to create web sites that start out quite small but can, if necessary, keep up with exponential growth. A forum that in the beginning might not require the full processing power of one service computer can automagically expand, with the same user experience, to operate on hundreds of computers.
Another bit of technology that helped members of WallStreetBets pump up the price of GameStop was the cell phone video game. In 2015 the brokerage firm Robinhood introduced an app that made buying and selling stocks (and also options later on) much like playing a video game. This and one other innovation gave video-game playing young adults access to the stock market. The other innovation was to allow traders to buy stock in dollar amounts.
Stocks are actually sold by the share. On the Friday before the 2021 Superbowl for example an Amazon share sold for $3,352.15. An investor with $500 to spend was out of luck. However by 2015 computer bookkeeping had gotten to the point where a broker could offer a buyer a right to a fractional part of a share. Actual share ownership is kept in the broker’s hands, buyers trust the broker to keep track of the value of their fractional shares and to pay them the value of those fractional shares whenever they ask for it.
Brokers in the U.S. can be trusted to do this because of rules enforced by the Securities and Exchange Commission (aka the SEC) and the punitive damages handed out by courts when there is malfeassance or gross incompetence.
Like all other brokers Robinhood permits qualified clients to borrow some of the money they use to buy shares. Like a few brokers Robinhood does not charge a fee for buying and selling stocks. This is possible because of the complicated way such transactions take place. At any given time there are numerous requests to buy or sell some number of shares in a given stock. Instead of trying to match those requests with each other there are companies who get in between the buyers and sellers. They buy shares, hold them for a bit, and sell them in repackaged form. Either they sell for more than they pay or they charge a fee or both. This difference percolates back to the broker and the individual investor. I pay my broker a fee to try and find the best price. Robinhood’s clients avoid the fee and take the price Robinhood offers them.
So Robinhood has been very attractive to members of WallStreetBets because it offers a video game like interface, the ability to think in dollars rather than shares, and fee-free transactions.
WallStreetBets motivates investors. Robinhood enables them. Recent advances in computer technology make both possible.
By the way I intentionally used the word “pump” in describing what the members of WallStreetBets did to the value of a GameStop share. I did this because I saw the word used in the WallStreetBets forum. I doubt though that those who used that word were aware of its legal meaning, as in “pump and dump”. This is an illegal activity that involves buying stock, making fraudulent claims about the company’s prospects, and selling the stock before people discover the fraud. Authorities are investigating whether some of that happened with GameStop’s rise in value. I have no opinion on the matter except to believe that if there was any fraud, very few people were involved.
There were other players in the rise and fall of GameStop’s share price. These players were focused on GameStop’s future prospects. GameStop sells video games from retail stores located in malls. Mall traffic is down. Online selling of everything including video games is up. The traditional view on Wall Street is that GameStop is one poor investment. When the bubble began several hedge funds had short positions.
To understand how a short position works you need to know that there are funds that are holding on to GameStop shares in spite of the general opinion on Wall Street. One reason for this is that GameStop is a part of some stock indexes. A fund designed to track such an index will hold onto GameStop.
So here are the mechanics of a short position: Suppose I have a share in GameStop and plan on holding it. I can offer to loan my share to some other investor. An investor who thinks the price of a GameStop share will go down will borrow my share, pay a me a small fee, and sell that share to someone else. In this case we are imagining a hedge fund borrowing the share and selling it to a WallStreetBets investor. Now over the past twelve months GameStop shares have been priced at lower than $4 and higher than $400. Suppose the hedge fund obtained my share when it was worth $4 and sold it. If the price dropped to $2. The hedge fund could buy it at that time, give me my share back, and make a 100% profit (less small transaction fees). But if the stock rises to $400 and I demand my share back the hedge fund would be forced to buy it for $400 so they could return it to me. Their loss would be on the order of 9900%.
Hedge fund managers have seen bubbles before. They won’t let their losses grow to anything like 100% let alone 9900%. They will buy the shares they are short in and give them back. This happens when a share price is rising and it creates even more buyers for a stock that already has too many. The effect is to make the stock price rise even more.
Naturally the knowledge that this was happening elated the members of WallStreetBets and gave some meaning to the notion that they were acting like Robin Hood, at least in so far as the part about taking money from the rich.
Of course that is not the end of the story. As I mentioned, hedge fund managers have seen bubbles before. They know that to make money on a bubble you have to be real smart timing your buying and your selling. Inhumanly smart. Algorithmically smart. And they have the wherewithal to buy sophisticated algorithms.
Two kinds of algorithms are important here. One kind spots short term market trends and makes trades that take advantage of those trends. The other kind scans the entire digital world for interesting patterns and reports those patterns to human beings. The first kind of algorithm can be used to trade in and out of stocks with a lot more sensitivity to short term trends than the clients of Robinhood can do. The second kind of agorithm helps fund managers predict state changes.
There is lots of data for these algorithms to process. They train on the past and use the present to do their thing. The first kind of algorithm works with all the individual requests for buying and selling stocks. The second kind works with company reports and social media (like Twitter and WallStreetBets). Training of both kinds of algorithms is ongoing and improving. An AI process called machine learning does the training. One reason we are seeing the effects of this kind of training now is that has taken time to educate enough people in its use.
There are winners and losers among both individual and professional traders. The recent hype that the scale had tipped in favor of the individuals is probably wrong. See reference 2.
Finally let’s look at how Robinhood failed its clients as the GameStop bubble burst. The failure happened because Robbinhood’s finances could not keep up with its computer technology.
I’ve mentioned that the SEC has rules to make sure the players in complex stock trades can meet their obligations. These rules require brokers to put up money to cover the possibility of a default. The amount of money required depends among other things on how risky a broker’s deals seem to be. A stock whose share price can move by several percentage points in a day is risky. Shares in GameStop became more than risky and the amount of money Robinhood had to put up grew by 10 fold. They couldn't pay for such an increase and so they solved the problem another way by cutting the risk. This they did by prohibiting trades in risky stocks until they could raise more money.
Prohibiting trades in risky stocks meant that clients who held positions in those stocks couldn’t get out of those positions. You can imagine the kinds of things these clients had to say on WallStreetBets about Robinhood.
Robinhood was not the only broker that imposed restrictions on risky stocks. Robinhoods restrictions however were soon lifted, at least partially, as it was able to raise enough money to cover its obligations. This hasn’t stopped lawsuits claiming that financial mismanagement on the part of the broker caused financial pain on the part of the clients.
All in all this was a typical bubble. Some novices made lots of money, some lost large amounts, and the pros at least muddled through. What spiced it up and made everything seem new was the technology that was in play.
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References
https://news.yahoo.com/reddit-banned-group-wallstreetbets-moderators-193311755.html
https://www.washingtonpost.com/business/2021/02/08/gamestop-wallstreet-wealth/