Who Shot the Sherriff?

I returned to the states in March, and as I walked through an airport that seemed to have suffered a neutron bomb strike, I knew life would be different for a while. I wondered what distractions would appeal to people locked in their apartments for weeks on end.

One that did not occur to me was that they would become day traders. Oddly, or perhaps inevitably, there was a firm perfectly positioned and, in some ways, built around that idea. We are, of course, referring to Robinhood – “take from the rich and…well, you know the rest.”

Robinhood is a gamified trading application specifically designed for the HENRY market. A HENRY is person that is a High Earner Not Yet Rich. Just picture millions of twenty-something HENRYs, stuck at home, spending their time online for work, for socializing, for playing Call of Duty and for watching the pandemic news.

The stock market is crashing, and oil prices have gone negative! The volatility is huge. This could add some excitement to the day.

Then, suddenly, the government drops $1,200, into their lap and a friend sends an invitation to open an account so they can win a free share of stock on Robinhood. But they have never bought a share of stock or an option before. Not a problem.

Over half of Robinhood’s accounts have never invested before. One of the firm’s stated goals is to overcome psychological barriers to playing in the market – like experience and competence.

And there are no sports to watch or bet on. And, like everything else on the Internet, it’s free to play. It’s ok! Everyone’s doing it!

Robinhood fell into a perfect storm, attracting exactly the types of users (or are they investors?) they wanted. The app brought together all the favorite attributes of the online cognoscenti: a simple game style interface, a social network to create a community, and crowdsourcing investment advice. According to the WSJ, the app also taps into the known behavioral biases that drive investor behavior, even using “Netflix-style” recommendations.

After all what is the difference between sharing a music playlist and a list of stocks to buy or short? Well, there is one difference; if enough followers chase your trading advice, Robinhood will pay you 2% of their trades. This is in addition to what you can make front running your followers.

The business took off like the proverbial valley unicorn. Robinhood has a whopping 13 million accounts, however, the average size is under $5,000 (compared with E-Trade at $69,000). The median age of their clients is also just 31. With so little capital, these “investors” are quickly attracted to cheap stocks (bottom fishing) and bets in the options market.

So, the walking dead of the pandemic (airlines, cruise lines, hotels) were hot on Robinhood. When oil prices went negative for future delivery, Robinhood investors loaded up on an ETF built on complex energy options and futures contracts, called U.S. Oil Fund. No doubt the name alone was enough for an informed investment decision. U.S. Oil Fund crashed in April and they are now subject to an enforcement action by the SEC. Most firms will have warnings on these investments like, “Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors.”

It is easy to trade options with the app. Instead of some complicated screen asking whether you want to buy or sell puts or calls, there is a simple button that declares, “I think it’s going up!” or “I think it’s going down!” No worry about volatility or liquidity or all those goofy Greek letters. In fact, the firm gives easy access to binary options. What?

The binary option is the perfect contract type for this market. It is a simple over-or-under bet on a stock price or an FX pair. The payout is always either $100 or zero, but prices vary. The options are short-dated from a week to 5 minutes or 60 seconds. This is the market equivalent of buying a lotto scratch-off card.

So, if everything is free, how does Robinhood make money? Selling user data and advertising like every other app? Not quite. They sell client trades in a process actually invented by Bernie Madoff – yes, that Bernie. Most brokerage firms do not execute your trades because they do not have direct access to the exchanges. So, they send the trades to another firm for execution. And those firms pay handsomely for that “order flow.” In the first six months of 2020, Robinhood raked in over $270 million compared to $190 million at E-Trade.

There have been consistent rumors that Robinhood was delivering order flow to high-speed traders (HST) who use the flow to increase their margins. In essence, the HST have more data and welcome the opportunity to transact with less informed punters. When that happens, of course, the quality of execution (pricing) can get worse. In December, Robinhood was fined $1.25 million for “best execution violations.” On September 3rd, the SEC launched a civil fraud investigation because the firm failed to disclose this source of revenue to customers.

Robinhood also comes with the requisite social justice bona fides. According to the founders, the Occupy Wall Street movement inspired Robinhood. Their goal was to democratize investing. As Vlad Tenev put it in an interview, “Robinhood is liberating information that’s locked up with professionals and giving it to the people.”

We doubt that the intense FarmVille players, the ones that paid real cash for new tractors, ever became farmers. So, it remains to be seen whether the Robinhood crowd will graduate to become serious investors. Our worry is that after playing the game for a while and losing their COVID relief money, these HENRYs will be turned off to investing in the same way that the mortgage crash of 2009 put a damper on their enthusiasm for the real estate market.

-Jim

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