I didn’t expect to be writing about Robinhood again so soon (actually ever) but circumstances change. The day I published last week’s article, Robinhood immediately became a meme stock jumping 50% in a day. So what happened?
The Call Squeeze
The Wallstreetbets (WSB) crowd went back to one of their favorite tricks like a band playing its biggest hit at the end of the show. They manipulated the options market. This is a favorite WSB tool going back to Tesla before they even thought about GameStop.
What the WSB investors have learned is that the options market is less liquid than equities and thus easier to manipulate. Option prices are linked to stock prices and so when you buy an option, the market maker will hedge that with common stock.
If you buy a lot of options, the market maker has to buy a lot of stock. If you buy a lot of out of the money options, the market maker has to buy even more stock (it’s a math equation based on options pricing). By the way, out of the money options are cheaper than near the money, so $1000 buys you a lot more $100 calls on a $50 stock than it buys $60 calls.
Thus, it is easier to influence a stock through the options market than buying the stock directly. Rather than you having to buy $100M of stock, you can maybe buy $1M of options and force the market makers to buy the $100M of stock (I’m not saying that’s the exact ratio, just illustrating the concept). It is the same market impact but requires a lot less capital on your part.
The WSB crowd understands this math and, as we know, looks for highly shorted stocks and buys big out of the money calls to force a short squeeze. Normally, we think of short squeezes being news related. There is a big short position and the company reports positive news, so the shorts panic and cover.
An options driven short squeeze is different. There is no news. Someone buys the calls, the market makers are forced to buy, the stock starts to go up, and the shorts get spooked by the price action and panic cover. It’s like a bluff in poker. It doesn’t work every time, but it works a lot of the time.
By the way, this is the same thing the pros did during the Financial Crisis. The difference is they bought out of the money puts to force selling in stocks and the declining stock prices spooked the counterparties who asked for more collateral which put more pressure on the bank and sent the stock down more.
Anyway, you might be thinking about now, “that makes sense but…wait, Robinhood was an IPO. It didn’t have a big short position“. That is correct. So what happened?
The New Twist
When a stock goes public, there are not instant options available. The market makers need to see some price action to feed their models and determine prices. It is no surprise that the liftoff in HOOD came only when the options finally appeared.
While there was not short interest to squeeze, the market makers had likely been pricing the calls off the first few days trading where the stock was flat to down. Thus, when the options first appeared, WSB saw an opportunity.
Apparently, they targeted the $70 calls (with the stock trading at about half of that). By aggressively buying the $70s, they caught the dealers offsides and they had to scramble to buy a lot of stock. This set the wheels in motion.
So the twist was, rather than squeeze the shorts, WSB squeezed the options market makers. This was a pretty savvy move and will probably change how options are rolled out after IPOs going forward.
Notice how the stock topped out around $70. That was the end of the game. Whoever bought the options probably cashed out there and locked in their gains. Speaking of locking in gains…
The VC Hares
Recall in February when Robinhood had to raise emergency capital during the GME fiasco? Do you remember thinking how are they going to convince anyone to invest now? So how did they do it? Because they gave away very appealing terms.
Investors were promised a 30% discount to the IPO price. As long as Robinhood could get to an IPO, they would have a 43% gain (e.g. buy at 70, sell at 100)! And they probably only had to wait a few months to realize that gain!
And, by the way, if they did nothing, their existing holdings may have gone to zero! So they saved the value of what they had and made 43% on the new money. That’s hard to refuse! It’s like the ultimate “rights issue”!
Why do I bring that up? Cause guess what else these VCs got? The right to sell with essentially no lockup post the IPO. Thus, if there was a first day pop, they could quickly dump their shares into the strength. This was important as the investors probably guessed there might be a lot of investor interest in shorting HOOD after the deal so they’d want to get out first before the selling pressure arrived.
So, no, the private investors didn’t get to sell on a first day pop. They had to wait almost a week instead! But when the option strategy played out and the stock spiked, the private investors filed to sell. Even with the stock coming off from $70, they are still up 50% from the IPO price at $57. Thus, they will have more than doubled there money in six months!
The great irony is the WSB participants are all against the “evil” institutional investors like hedge funds, but they don’t mind enriching venture investors who benefited from investing at vulture terms from conditions WAB helped create!
Now, there is one thing these Venture Hares couldn’t have counted on and that’s the SEC stepping in to muck things up. The SEC is “reviewing” whether the sales should be allowed.
It’s hard to see what basis the SEC has for not allowing these sales, but they can drag their feet approving the registration statement and potentially affect what price the sellers are ultimately able to realize. However, this could also backfire if WSB decides to swarm some $100 calls and see if they can play the game again!
Lessons?
Are there good lessons to be learned from this episode? Hmm, I can’t think of any. We have learned a few things though.
First, if you do dumb things (like provide options without accounting for tail risk), eventually the market will find you and drag you down.
Second, Warren Buffett isn’t the only one who can take advantage of companies in their darkest hour. But at least Buffett has the decency to not flip the trade six months later.
Third, WSB may do some dumb things (and arguably some unethical things), but they also do some smart things like exploit weak hands.
Fourth, notice I never mentioned Robinhood’s fundamentals! They are irrelevant to how the stock is trading and will likely remain so for some time.