Individual investors have acquired market-moving power thanks to online forums and coordinated options strategies. Some hedge funds are now following their trades with algorithms to anticipate their moves.
The boom in retail trading has led to a major change in the markets. Retail investors have become a new market force that can no longer be ignored. True, retail investors used to form the rear guard in the stock market. At the forefront was the smart money, or sophisticated investors, who had privileged access to information and who were the first movers on stock market trends and opportunities.
The small investors, on the other hand, were typically the last ones to hear about a stock and buy it usually at the top of a bubble. As the saying commonly went, when your taxi driver or hairdresser started talking enthusiastically about a stock, that was your reliable cue that everyone was in the market and that you should sell.
But things are evolving. In the last two years, trading forums have changed the order of things. «Individual investors have discovered the power of collective trading without a financial analyst», says Valérie Noël, head of trading at Syz Group in Geneva. «A favourite forum has been #WallStreetBets on Reddit, but they come in many forms, including Telegram groups, Twitter Influencers, Tik Tok and more».
She says that online forums have allowed two things: access to information for small investors and the pooling of their trades, which helped them to organize and gain critical mass. The key example is GameStop. In early 2021 this stock was at the center of a famous show of strength between individual investors meeting on reddit and sophisticated hedge funds. The contest showed how those forums allowed small investors to coordinate their strategy, challenge the big shots (hedge funds) and actually move the market. The Reddit/WallStreet forum was able to identify huge short positions by some hedge funds on some «meme stocks», and to convince a «retail army» to trade at the same time against these hedge funds.
The key weapon in this strategy was options. It enabled small traders to defeat giant hedge funds. «Weaponized options trading», as the «Financial Times» calls it, turbocharges rallies. So even though retail traders don’t have the assets under management of pension funds or hedge funds, they can move the market, because options trading leads bigger players to hedge themselves: if enough people buy 40 $ calls on a 35 $ stock, the big players will have to hedge eventually.
«Options trading has led to massive gamma trading activity (dealers hedging themselves) and this indeed moves the market», says Valérie Noël. Gamma measures how much the price of an option accelerates when the price of the underlying security changes. In other words, hedge funds are forced to close their shorts, pushing the stock up and attracting even more longs into the position. The big players eventually surrender to the retail army. «But it didn’t work on all occasions», says the Syz trading chief: «for instance, the long silver trade was a losing bet for the retail army».
In the midst of the options frenzy, the financial press described these retail strategies in a flowery language, such as «blitz purchases» by «colonies of ants». A record of 39 million options contracts have traded daily on average in 2021, up 35% from 2020. Retail investors now account for more than 25% of this trading activity. However, the head of trading at Syz points out that «the majority of these small-time traders are buying the most basic call and put options, which have a much lower probability of profit compared with advanced strategies like option spreads». Still, even simple options provide leverage: «You don’t need the same amount of money to move the market, as gamma hedging exacerbates the moves in one direction or another», explains Valérie Noël.
One surprising consequence of the new power of retail investors is that the big are now tracking the small, says Noël: some hedge funds are following the flow of retail traders and trying to anticipate those feedback loops. One hedge fund tactic is to use algorithms to anticipate gamma hedging, and thus tracking the retail traders’ moves. In the case of GameStop, the goal would be to identify the retail strategy and go long the stock while closing the position before they exit.
Another strategy is to be contrarian and bet that the retail traders will ultimately be wrong. In the GameStock example, that would mean going short on the stock at some point. But this strategy didn’t go well in the case of Tesla, when many hedge funds took short positions and were wrong for some time. The defeat can be all the more humiliating as those «fights» are now commented live on Twitter, with a typical blend of boast, jest and mockery.
One consequence of retail trading is its multiplier effect, acting as leverage, amplifying moves both ways. A «portable bubble» of sorts. A good example is what is happening now with the Ark Innovation ETF, the flagship fund managed by Cathie Wood’s firm. In early 2021, many retail investors were impressed by the massive outperformance of the fund and decided to mimick the fund’s trades. An app was created to share the information on an even more timely manner.
At first, this created a virtuous circle: the better the Ark performance, the more the trades were replicated, the more the underlying stocks were rising, the more money went into the fund and the stronger the performance of the ETF, etc. But now that the fund is in a downward tailspin, a vicious circle is taking place.
With the fund dropping, there are more redemptions and more retail investors selling the underlying stocks, hence pushing their prices even lower… «This is how retail investors got punished and have left the market for some time», says Valérie Noël. But they will be back, a whole generation of veterans trained on handling options on the front lines of GameStop, Tesla and many other trades.