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LESSONS FROM ROBINHOOD TRADING FRENZY

Published

2020

Tue

11

Aug

Lockdown boredom boosts risky derivatives trading

 

11 August 2020: Stock trading is no longer the exclusive club of the old, rich and financially astute. Whether it is down to an ever increasingly astute consumer or lockdown boredom, the amount of people taking to direct equity trading platforms is fueling widespread debate. However, regardless of whether it is a long-awaited democratization of stock markets or a ballooning gambling bubble that could burst with dire consequences for newbie traders, the need to keep sound investment principles in mind remains.

 

This is according to Evan Giannakis, Head of derivatives at Momentum Securities, who says that current data indicates that more than 2% of all volume in equity trades in the United States is made up of trades of $2000 or less. “There are a number of factors driving this phenomenon. Firstly, the US Federal Reserve has flooded the market with unprecedented levels of liquidity, aggressively buying bonds in the open market.  This bond buying spree has underpinned the equity bull market as well. Secondly, low cost platforms like Robinhood have opened up equity and derivative investing to a whole new segment of the population.

 

“Combine this with the fact that we are in an environment where sporting events have been cancelled, entertainment businesses are running at much reduced capacity and people are sitting at home receiving government stimulus cheques. What we are seeing can actually better be described as wagering on “sure things” with leverage rather than investing,” says Giannakis.

 

He points out that half of Robinhood’s new customers this year said they are first-time investors, according to the company, and more than 2 million new accounts were opened in the first quarter. “The platform has also come under fire recently after the tragic suicide of a 20-year-old investor, Alex Kearns, who mistakenly thought he had lost $730 000 (about R12.5 million) when in fact the other side of the trade had not yet settled. Bloomberg recently reported that ‘lawmakers pressed the company on how it determined which users can access risky investment strategies, such as options trading’,” said Giannakis.

 

According to Giannakis, this raises a very serious point about understanding the risks involved with trading shares and options, also known as derivatives, and whether your financial situation can weather these. “While we advocate the opening up of markets to the ‘end investor’ – and we don’t believe that professionals and industry should be the gatekeepers – we want to urge people to tread cautiously. Especially with intricate trades like derivatives; which worryingly saw the biggest growth in recent months”. He adds that many people are also making short term ‘day trades’ – where you buy and sell a share in the same trading day – usually the ambit of very experienced traders due to the risk involved. 

 

Giannakis explains that single-stock futures, a type of derivative, are future contracts on individual stocks between two investors. The buyer promises to pay a specified price for example for 100 shares of a single stock at a predetermined future point. The seller promises to deliver the stock at the specified price on the specified future date. Investors have to put up 20 percent of the value. Unlike owning the actual underlying shares, single stock futures do not convey voting rights or dividends.

 

“Out of the four broad assets classes: property, bonds, cash and equities, equities traditionally are considered the riskiest. Trading equity derivatives on margin ratchets up this risk considerably,” says Giannakis. “You are essentially betting on something that doesn’t currently exist – it’s an expectation of what you think that stock will look like at a future point in time.”

 

“To illustrate, let’s assume you buy a R1million house. You put down a R200,000 deposit (margin in derivative contract terms) and borrow the remaining R800,000 from a bank. Your intention is to sell this house at profit at some point in the future (a long position), however, suppose your house is revalued every day. Should the value fall below R1million, you will have to settle the difference with your bank at the end of the day. This is what is known as a margin call.”

 

“If the market moves against you it can be very scary. Using the house example, you can lose R1million on a R200,000 investment. On a short position, where you are betting that the price of your investment will go down, you can in theory lose a lot more. In an overheated market this strategy is very dangerous for retail investors, particularly at a time when institutional investors are flocking into traditional safe havens like gold, a canary in the mine,” warns Giannakis.

 

“That is not to say that there is no place for derivatives in your portfolio – but you need to understand what you want to achieve with them in the longer term and whether you can weather the risk,” he adds.

 

Giannakis shares his top three tips on derivatives trading below:

 

  • Day trading is more like entertainment than investing. And like all entertainment, it will cost you money. If you don’t want to lose money, don’t day trade.
  •  
  • Owning one stock, or even a group of stocks, is risky because companies can and often do go out of business – especially in our current climate. So share the risk by owning many stocks. An easy way to do this is by investing in an Exchange Traded Note (ETN) or Exchange Traded Fund (ETF). For example, our ETN is a South African Rand denominated note that allows individuals the opportunity to gain local and international equity exposure.
  •  
  • Stay away from trading derivatives or using margin unless you’re an expert investor — or get help. As a rule of thumb, if you didn’t know what derivatives were before reading this article, you’re not an expert investor. At Momentum Securities, we assist our clients with derivative strategies in our partially managed portfolios. Our advice to clients is to first and foremost fully understand the associated risks when trading derivatives on margin. Be clear on what you are trying to achieve, what your end goal is and importantly do not invest more that 15% of your portfolio in derivatives.
 
Source: MSL Group
 
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