Is Robinhood The Next GameStop?

Is Robinhood The Next GameStop?
Stéphane Renevier, CFA

over 2 years ago5 mins

  • There are five factors driving Robinhood’s stock price: support from investment gurus like Cathie Wood, gamma squeezes, regulatory risks, insider selling risks, and high retail participation.

  • But while the bullish factors are fading, the bearish factors are set to grow – which could make the stock an incredibly risky bet.

  • So unless you’ve got a process in place to trade such opportunities, you’re probably best to stay away from Robinhood’s shares.

There are five factors driving Robinhood’s stock price: support from investment gurus like Cathie Wood, gamma squeezes, regulatory risks, insider selling risks, and high retail participation.

But while the bullish factors are fading, the bearish factors are set to grow – which could make the stock an incredibly risky bet.

So unless you’ve got a process in place to trade such opportunities, you’re probably best to stay away from Robinhood’s shares.

Mentioned in story

Something peculiar happened to Robinhood’s stock last week: it nearly doubled in value after a disappointing market debut just one week prior. Now, investors reckon it could become the next GameStop. But if you jump on the bandwagon, you’ll likely end up disappointed. Here’s why.

What the heck happened with Robinhood ?

Robinhood went public the week before last, and things didn’t quite go to plan. The broker’s shares ended their first day of trading 8% lower – one of the worst initial public offering (IPO) performances ever for a company of Robinhood’s size.

For all intents and purposes, the IPO appeared to have failed. But the following week painted a different picture: Robinhood’s shares rallied 1%, 7%, 24%, and then 50% over the next four days. Last Wednesday, gains were so high that the Nasdaq halted trading of the stock. But by Thursday, things had turned sour once again, and Robinhood’s shares dropped 28%. As if that wasn’t turmoil enough, the stock bounced back on Friday and ended the week 45% higher than its IPO price.

Robinhood’s wild stock movements since the company's IPO on July 29th
Robinhood’s wild stock movements since the company's IPO on July 29th

What’s driving Robinhood’s crazy price swings?

There are currently five factors driving most of the price swings in Robinhood’s stock, and – surprise – none of them are the company's fundamentals.

Two factors pushing the stock price up: Cathie Wood and a “gamma squeeze”.

Upward momentum started to really gather pace when Cathie Wood – CEO of Ark Investment and esteemed finance guru – announced that she had bought Robinhood stock for a number of her funds. That was enough to convince investors sitting on the sidelines to scoop up some shares and bring the stock back to the headlines of meme forums like Reddit’s WallStreetBets.

But another factor played an arguably even bigger role. Last Wednesday, Robinhood stock options became available for trading, which let retail investors use leverage to bet big. For a small upfront fee, investors have the chance to buy a large number of shares at a pre-ordained, cheaper price if the stock rises beyond a certain level. Every time you buy a “call” option like this, the bank selling the option must hedge its risks by purchasing the stock. And that pushes prices up in what’s called a “gamma squeeze”. The higher the stock price goes, the more people want to buy call options, and the more shares banks are forced to buy – sending prices skyrocketing.

Two factors pushing the stock price down: regulation and insider selling.

In the week leading up to Robinhood’s debut, news around potential regulatory action became increasingly negative – and that certainly played a role in the stock’s weak performance on IPO day. But when the stock dropped 28% the following Thursday, there was another factor at play: reports had surfaced that early investors and Robinhood insiders were about to sell a huge amount of their shares.

One factor to rule them all: high retail participation.

The four main reasons why Robinhood’s stock rose and fell don’t explain why the stock moved so much. For that, we must turn to the extremely high participation of retail investors, which turned Robinhood into a meme stock. It all started with Robinhood’s rather unique decision to allocate 35% of its IPO shares to its own retail customers – typically, they wouldn’t get much more than 15%. Retail participation snowballed further when options became available and the stock was making headlines on every retail forum. Now that retail investors are more or less in control of Robinhood’s stock price, everybody’s wondering where it’ll go next.

So is Robinhood the next GameStop?

All the ingredients seem to be there for some GameStop-like action to occur. But there are three reasons why gambling on Robinhood might not end well.

First, it’s not if but when will insiders sell their stock. Prices rebounded after Robinhood assured the market that insiders couldn’t sell shares before getting clearance from the SEC. But make no mistake: insiders might still be planning to sell, they just can’t do it yet. And clearance could very well happen soon after the company reports earnings on August 18th.

Second, it’s not if but when will regulatory risks be priced in. Robinhood’s stock price remains heavily driven by news around changes in regulation, and for good reason. 81% of the company’s revenues are derived from “payment for order flow” – a practice that regulators are currently assessing and have the power to ban. And given the stock’s high valuation, it seems that the market isn’t pricing the risk correctly.

Third, it’s not if but when retail interest will turn. For retail investors to engineer a squeeze on a stock, they must all be united. But sentiment on Robinhood has not been unanimously positive since the broker halted trading on GameStop stocks a few months ago. And the investors that are positive might soon decide to bank their profits anyway, and turn their attention to the next target. In fact, data from swaggystock.com shows this has already started to happen.

Should Robinhood best be avoided then?

Unless you have a clear strategy in place to profit from these types of things, you might want to avoid buying into the craze. Impulsive, attention-driven purchases can be exciting, but they’re likely to lose you money over the long term. And in this case, the odds of a sustainable retail-driven rally seem particularly low. That doesn’t mean the stock isn’t a good long-term investment, mind you – only that its current volatility will make it hard for those who want to buy and hold.

Of course, you might disagree. If you do want to buy into Robinhood, take these three small pieces of advice. 1) Size your trade like you have a 50% chance of losing it all – and chances are likely even higher. 2) Plan your exit now rather than when the stock starts to drop. You could, for example, use a trailing stop loss as a guide. 3) Visit this website to help identify a potential switch in sentiment.

Whatever you end up doing, pay close attention to how your emotions are influencing your decisions. If you can resist the temptation to buy on impulse – and choose opportunities that fit your strategy instead – you’ll be well on your way to becoming a successful investor. And remember to judge your decision not by the final outcome, but by how well you respected your own process.

Stay safe out there, Finimizers.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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