Robinhood finally had its IPO last week. While the stock initially fell a bit from the IPO price (though broke out yesterday on news that Cathie Wood bought some), any new listing valued at $30B is a pretty successful outcome.

Still, one has to wonder if the IPO was “marking the top”, sort of like a Barron’s or Economist cover where the attention is a sign of excess positive sentiment.

When Making Money Isn’t the Goal

Robinhood’s business model is very simple. The more people trade, the more it gets paid. Note, it doesn’t say the more money their customers make investing, the more they get paid. No, the more people trade, the more they get paid.

So right away, Robinhood is at odds with its customers. For those who believe buy and hold is the secret to higher investment returns, well, Robinhood probably doesn’t mind if you do your business with Vanguard.

On second thought, maybe Robinhood isn’t at odds with their customers, i.e. people who are seeking action and excitement rather than just the highest investment returns. For those people, they provide a better service than the curmudgeonly alternatives who preach maximizing financial returns.

After all, it can be rational to buy lottery tickets. No, not because the odds are in your favor, but because people get non-monetary utility out of the excitement. For some people, the non-financial utility is worth more than the negative expected value of buying the ticket.

If you are one of those people, gambling is no more irrational than someone who spends their money on designer clothes or fancy cars. Those are also bad ROIs that are offset by the utility people gain from them.

So maybe Robinhood is providing value to people who value action over compounded annual returns. The question then is how many of those people exist and has Robinhood already found them all?

As Good As It Gets

If Robinhood is driven by trading volume, then we need to understand what drives trading volume. Bull markets drive trading volume. Bubbles drive trading volume. “This time it’s different” drives trading volume. People sitting at home bored during Covid drives trading volume. Stimulus checks drive trading volume. Meme stocks drive trading volume.

How many of these things are likely to continue? Most of what is driving trading is a fad. It is a temporarily fun thing to do, especially given the lack of alternatives in Covid world.

Or they’ll get bored and move on to the next fun thing. Who knows, maybe disco will come back? Or break dancing? Maybe they’ll find a new video game to be addicted to?

At some point, people will start losing money and it won’t be fun anymore. Bull markets don’t last forever and they usually end in tears.

Whatever the cause, people will lose interest and trading volumes will decline – and so will Robinhood’s revenues. And they’ll keep declining probably until the next generation’s tech bubble.

The Gambling Alternative

If the popularity of Robinhood is driven by the excitement factor rather than the investing returns, what other ways could you play this investing theme?

How about actual gambling? While stock trading may be near a cyclical peak, there is a gambling alternative that appears to be in its early innings: sports gambling!

With the legalization of sports gambling, you have a trend that is still in the first or second inning. It is not hard to imagine a time where even casual friends are betting on games.

Think how many people play fantasy football. Is putting $100 into a fantasy league any different than betting $5 a week on individual games?

One of the reasons the size of the stock trading audience is limited is because many people feel overwhelmed by investing and that they don’t know as much as the pros. When it comes to sports though, most fans feel they are experts and know more than the talking heads on TV.

And the size of the professional gambling community is much smaller than the professional investing world, so it is easier for a savvy fan to have an informational edge relative to a day trader.

Thus, if we were to talk in terms of “TAM”, I would argue the size of the potential sports gambling universe is much larger than the retail investing audience, especially when we look at the “ATAM” = the retail investors who want action rather than long term financial wealth.

Yet, Robinhood now has a $40B market cap and the sports gambling “disruptor” DraftKings is only at $20B.

Now, there may be good reason for that. I have not done a deep dive on the long term earnings potential of either, but, on the surface, I think it’s a lot easier to tell a story where DraftKings has a larger share of a larger market than Robinhood‘s share for retail trading.

Regulatory Tail Risk

There’s one other big consideration when thinking about Robinhood – the regulatory risk. As I noted, Robinhood makes all it’s money from trading volume. Specifically, it gets paid for “order flow” by securities firms. This is why they can make trading “free”.

As we all know, “there is no such thing as a free lunch”. Robinhood let’s you have for free the thing you can see – the commission – and charges you for the thing that is harder to see – the execution of the trade.

In other words, if you buy 1000 shares of stock and you pay 2c more per share because of worse execution, then your effective commission was $20, not $0.

Now, there are a lot of differing views about whether investors are truly hurt by payment for order flow. Or, if they are, if the cost is more than the alternative of paying commissions. I’m not going to engage in that debate. Rather, I’ll make two observations:

  1. Most customers don’t know that they are still paying for trading and thus Robinhood is manipulating them.
  2. The SEC is very concerned about payment for order flow and may ban it. This is a major business risk for Robinhood.

While we can be morally troubled by the first observation, the more germane issue is the second. If the SEC bans payment for order flow, Robinhood suddenly doesn’t have a business model.

Typically, when companies have a large regulatory risk, it is an overhang on the stock and it trades at a big discount. Why does Robinhood not suffer from a regulatory overhang? Good question. Probably for the same reasons nobody cares that AMC may still go bankrupt. We live in a strange world.

Thinking Like A Robinhood Investor

I am not in the business of making trade calls on the blog. That policy is not changing, so you should consider the following more of a topic for further exploration than a recommendation. Robinhood stock may do very well for quite some time, as have many other stocks that appear significantly overvalued.

With that all out of the way, if I were to assume the mindset of a Robinhood investor and seek action, I’d swing for the fences and do what Robinhood investors like to do = I’d buy out of the money options!

However, instead of buying out of the money calls, I would look at deep out of the money puts to reflect the regulatory risk (as well as to a lesser degree the high beta to a market selloff).

Now, I don’t have access to Robinhood option prices, so it may be the $20 or $25 puts are expensive and not worth it. However, if they’re cheap because people think the stock will only go up, they might be worth a look.

As always, the risk with options (especially bearish ones) is they tend to expire before you get paid, so you need to think of the cost in terms of having to roll that contract several times before the trade works (which is why I – not being of like mind with the average Robinhood investor – tend to avoid options).

To be clear, I’m not taking any position – because I have a different risk tolerance than your average Robin Hood investor. My observation is mainly that the regulatory tail risk appears to be undiscounted in the stock.