On Friday, February 19, Lasse Pedersen joined Markus’ Academy for a lecture on GameStop and Predatory Trading. Pedersen is a Professor of Finance at the Copenhagen Business School and a principal at AQR Capital Management.
Predatory trading is trading that induces and/or exploits the need of other investors to reduce their positions. This leads to price overshooting and a crisis that spills over across traders and across markets. Demand moves prices of stocks but is not in of itself how investors typically make money — market impact is typically a cost. Rather, predatory trading is when predators force buying or trick buying and make money on the price increase caused by their orders. Spillover effects occur when the price keeps getting pushed up and more people have to liquidate.
During Gamestop, retail buyers pushed up the price which led to a short squeeze by hedge funds. On one day, the price opened at 112 and closed at 483, which is an astronomical increase in a day. Volatility by the end of January was above 300% annualized and the stock had over 200% turnover at the peak.
People who bought were not just retail investors discussing the stock on Reddit but also others. Retail investors were possibly driven by retail sentiment, including gamification of trading, GameStop belief and nostalgia, and the sense that shorting is “wrong”. Other buyers could be option hedgers, short sellers closing their positions, institutional investors, and other retail investors.
Robinhood restricted trading due to difficulty meeting their margin requirements. Robinhood has to post margin capital to clearing houses which grew from $125 million to $1.4 billion on January 28th due to the high volatility and an excess capital premium charge. They had to raise $3.4 billion from existing investors to cover this increased requirement.
Payment for order flow is the idea that Robinhood is paid money by market makers, such as Citadel, to execute their trades. Market makers want to earn the bid-ask spread and could lose money if there are informed investors about the fundamentals of the stock or there are large counterparties. Retail investors are therefore an attractive counterparty for market makers. This allows Robinhood to give retail investors the lowest trading cost although is bad for institutional traders.
Shortsellers had to liquidate their position because they could not sustain the losses as the price continued up. Volatility and size of their position increased as the price went up and therefore they started to reduce their position. Shorting costs for hedge funds were probably about 30% annualized in January. When the price collapsed, they made money on a much smaller base. The price fall could have been due to recent buyers and previous owners, but the price drop was only a matter of time.
Learned that demand moves prices, demand can be irrational, there are shorting complications and predatory trading, and the power of social media and IT.