Emergence of the Retail Trader

The wild ride with GameStop stock, Wall Street Bets, Robinhood and Melvin capital last month was an incredible moment for retail traders. Retail trading today is defined by ultra passionate investment forums, endless supplies of memes, zero dollar trading costs and easy access to powerful financial derivatives called options contracts. Everyone wants to know where these massive groups of traders will focus their attention next. Before you follow the retail crowd into the next short squeeze or moonshot idea, here are some considerations on how you can think about this new phenomenon.

Public information vs curation

There used to be an edge in having information. Today we have far too much information and that edge has been mostly replaced by curation. Public forums like Reddit are curation machines. Reddit’s WSB forum has thousands if not tens of thousands of ultra passionate and highly sophisticated traders who are spending hours combing through information, filtering for best ideas, and letting them rise to the top of Reddit via upvotes. This sounds way more professional than it is. It’s actually the wild west. This forum in particular has no pretense of professionalism, which is clearly attractive and entertaining to millions of people since it has 9.1m subscribers. Many of the research reports written within WSB are extremely high quality if you look hard enough to find them.

GameStop

The GameStop trade was a perfect storm of financial events. The narrative included 130% short interest (nearly illegal), a contrarian bet on an unloved global business, a possible bright future ahead and two recent celebrity supporters (Michael Burry and Ryan Cohen). That trade idea, which was high quality to begin with, was curated within Reddit and passed onto millions of investors who were free to use that information however they wanted. 

Once the momentum on the trade picked up, the members piled on buying as many call options and shares as they could while creating an enormous volume and variety of memes. My favorite meme was the GameStop Sea Shanty. Regardless of what happens next, the wall street bets crowd has a lot of fun together. This trade nearly broke Robinhood and some other major brokerages whose backend systems could not keep up. This will quickly lead to the renovation of the backend that powers our financial system.

Power to the people

Commission-free trading and easy access to options contracts are what finally opened the door for retail traders to fully participate in the public markets. The options contracts in particular are extremely powerful in that they offer instant leverage. Options can quickly turn into a 100% loss or, when you’re right, a 500% gain or more. The problem with that math is that it’s difficult to invest long term when a 100% loss is on the table. I’ll add more on that later. 

90% of the option order flow today is the size of 10 contracts or less, indicating they are retail trades. This happened for the first time in December and continues today. The retail trader is definitely here to stay.

The next opportunity

Many of the favorite trades of the wall street bets crew are strange, related to failing businesses or simply analyzed incorrectly. Others, like Tesla was prior to this year, are futuristic and possibly misunderstood.

Weed stocks are not a particularly good business model, yet the major weed stocks rallied +100% last week along with WSB retail sentiment after again crashing -50% in one day. Another one of their trades, the silver squeeze that followed GameStop, was not actually possible. When I say it was not possible, I mean that their analysis was incorrect and the short squeeze present with GameStop was not structurally possible in the silver market. That trade lasted just a few days.

While many of the Reddit investment ideas are difficult to agree with, there are some gems present. Palantir (big data and intelligence), SoFi (future of consumer finance), AMD (semiconductors) and Apple are a few of the current favorite technology and innovation-based businesses popular on Reddit. These are great examples of durable future investments, rather than short-term trades that could whipsaw your portfolio. People tend to underestimate what technology is capable of because of what it doesn’t or can’t do today. I’d guess that going forward, Reddit is likely to understand the future of technology better than a CNBC markets anchor. If you are already listening to CNBC anyways, you may want to check out Reddit.

Ergodicity is a key risk concept

Shifting topics to risk management, I learned about ergodicity from Nassim Taleb. It’s one of the key concepts from his Incerto books. Ergodicity points out that an individual’s personal experience is different from the average experience. When you invest in a momentum trade, like GameStop in January, here is what that ergodicity might look like:

• The average expected return for the entire group is positive. The winners will take most of the gains. Keith Gill’s original $50k investment in GameStop was worth $55m at its peak, or a 100,000% return in one year. If he is still holding, that value is probably around $10m at the moment. That skews the entire average into positive territory, regardless of the losses of other investors.
• The average expected return for any one individual is negative. In January, GameStop had a 5 day run of +130%, -44%, +67%, -30%, -60%. Anyone who had call options likely experienced a full loss. That kind of volatility can easily send an account value to zero. Remember that with a 50% loss, you have to earn a 100% gain to break even. Once you have multiple 50% losses, good luck ever getting back to even. If you do these trades enough times, trading in and out of assets that fluctuate wildly, you will eventually realize a full loss. Risk of ruin is unacceptable to long-term investors.

When looking for the next opportunity, avoid risk of ruin investments

Your best risk management tool is an intuitive one, simply don’t allow the risk of ruin to creep into your investments. Durable investments have strong management teams, quality business models, tailwinds in their respective sector, well-capitalized balance sheets and high reinvestment rates. There are many ways to invest alongside the retail frenzy. We especially like it when the retail investment forums pick up forward-thinking and forward-leaning business models, of which there are many today. It’s easy to get distracted by the headlines and crazy market madness. We hope that this perspective helps. Please share your favorite retail investment with us if you have one that you are passionate about.