Robinhood & Suicide (Regulation is coming)

I’m not sure if any of you have seen this. It’s a big story in the US. Specifically, as so many retail investors might be jumping into the markets. The interesting comment regarding this is the fact that Freetrade does not and has never considered any leveraged products on its platform. Any backlash on regulation or bad press is mitigated by this fact.

There are some interesting comments made by Scott and Kara on pivot if you want to have a listen.

@Viktor

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It wasn’t the leveraged products that seem to have been the issue, as he supposedly held both put and call options for a specific strategy, but rather he seems to have lacked fundamental knowledge with regards to how these products worked.

I don’t think the lesson to take away form this is to regulate and remove leveraged products but rather to expand education. You see this in the Freetrade forum with the number of people starting threads about ā€˜not getting the price shown’ when the issue lies with their knowledge rather than Freetrade’s systems. Investing is complicated and making it into a game removes something vital in my opinion.

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This is a really important read. Complicated products is a factor, but so too is gamification. I for one Never want to see little confetti poppers to ā€œcelebrateā€ a trade on Freetrade. It’s investing, not a game FFS. Apps like Freetrade and RH are important. They massively improve the status quo in a very meaningful way compared to traditional share trading accounts. But in creating easy access, all of the platforms need to be mindful of their responsibilities to protect vulnerable customers.

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I was in the pub about 6 months ago and there was a young guy (about 17/18) in there going on about how his mate had made loads from trading and that he was going to start doing it.
Basically this guy thought he could go from not knowing anything about the market straight into day trading and make easy money, that’s pure ignorance.
I agree its about education.

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It’s a really sad story. Without meaning to downplay the significance of the victim’s family’s loss- gambling is a huge problem and is the trigger for suicides, divorces, poverty and mental health collapses every day of every year all over the world. It should be a huge story all the time and we should work to educate people and limit the impact of it on people’s lives, rather than just blaming people for their weakness or blaming platforms for enabling them.

The fact that gamblers have had no sports to bet on, no jobs to go to, stacks of free money from the US govt and a seemingly limitless bull market courtesy of the Federal Reserve, seems to have caused massive stock market gambling from people like this.

It’s easy to blame whoever the poster child is at the moment - currently Robinhood - however ultimately we need to educate our friends, family and colleagues that piling more than you can afford to lose into any position is reckless gambling rather than investing and they are at extreme risk of losing all their money.

I don’t have any kids yet but I will be certain to make sure they understand this and if they do have an imbalance in their brain that predisposes them to speculating I will limit their bank and drill value into them for their first 18 years.

Obviously there will still be gamblers no matter what, it’s a behaviour that has been evolved through natural selection (imho), but we can at least educate each other to try to limit the downsides.

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All good comments but I think I might have misdirected or not explained the more significant issue that I see as a possible consequence to this event.

With ā€œbasic vanillaā€ buying and selling, you have the following possible extreme outcomes:

  • infinite upside
  • 100% downside

100% downside; This is a risk metric most people understand and are occasionally happy to take.

When it comes to more complex structured investment vehicles such as futures, options, you have the following possible extreme outcomes:

  • infinite upside
  • infinite downside (*depending on the LVR: Loan-to-Value-Ratio)

Infinite downside; This is a risk metric most people do not want to take. *And occasionally should not be allowed to take. (dependant on LVR)

As an example; before your approval for a mortgage on a house, your financial position and credit history will be scrutinized and screened by the lender. (I think LVR for UK home loans is 70% average? I could be wrong). So there is a regulator process to ensure safety, not only for the lender but also for the lendee. This regulator process was tightened after 2008 because of the irresponsible practises of some of the lenders. Obviously, with investments, the loan amounts could be much smaller, but the lending rates (LVR) are way more aggressive than home loans.

The biggest problem that has kept the lending rates and amounts intact is the fact that we are living in a world of 0% interest rates. The consequence of this is that financial institutions are more willing to lend money for these leverage, geared etc. products, as the delinquency rates are incredibly low. (We are at or very close to all-time highs: SPX). The addition of the extreme interest in online trading, recently, and incredible increase in volatility will unfortunately, exacerbate this issue.

However, we have not witnessed an ā€œeventā€ to curb or at least regulate lending from the financial institutions (in the 12 years I have worked in finance) when it comes to the infinite downside and the fact that the Federal Reserve announced 0% until 2022 two weeks ago, doesn’t deter the lendee and keeps them kicking the dept-can down the road.

I totally agree that education is a great tool and should be continuously improved and positively adds to the transparency we have seen within the financial industry in the last few years. However, I am in total alignment with the ideas of Freetrade on not allowing certain products on the platform to affect the future well-being of its users in a negative way.

All this really to say that I think Freetrade is in a great position, to reinforce this message. :grinning:

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Any option you buy or sell is unfortunately always leveraged. Its unfortunately built into the mechanics of how an option works. I hope that makes sense.

No it is not a leveraged product, the same way a legal contract is not a leveraged product. An option gives you the right, but not the obligation, to buy/sell a set number of shares at a particular price. There is no leverage at all. You are confusing the difference between the price of the options contract with the amount of shares it allows you to buy/sell.

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That’s if you buy the option. you can sell an option as well, which puts you on the hook to buy or sell the shares at expiry ( or just settle with cash). This can be a valid strategy but if you do it without being covered (e.g already owning the shares you might need to sell) you can end up with theoretically unlimited losses.

One valid use for this is selling calls against shares you already own. if the shares don’t go up you make some income from the options. if they do go up you just sell them at expiry and take the profit

They changed the rules on Margin requirements over here a couple of years back. I don’t think it would be possible for a novice investor to open positions that big with any of the of the CFD/spreadbetting firms or brokers operating in the UK even if they were hedged

Robinhood should never have let him open those positions.

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Regulation and education in particular definitely needed. Some stuff is super risky like trading and spread betting, a warning that x percent of people can lose money just doesn’t cut it. When people trading such huge amounts, they should be vetted somehow - providers have a duty of care.

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How does an option meet any of these definitions?

The word ā€˜leverage’ has very specific meanings in finance terms which do not apply here.

I am not arguing that risks are limited but these are not leveraged products. The same way that an oil company could have no debt and no leverage but still lose an infinite amount of money in an oil spill.

That is not what leverage means. Your losses can be larger than your investment in many examples without any leverage whatsoever, as per my oil example.

I am not, for a single second, arguing that you cannot lose more money than you originally spent when purchasing the option but that does not make it a ā€˜leveraged’ product.

It’s not a strict definition, it’s the definition. An option is a product which offers an asymmetric risk profile and hence the ability to lose more than the cost of the option itself but there is no leverage.

Okay so I could take $1,000 and buy 20 shares in XYZ company valued at $50 for a single share. Not leveraged, simple. Max loss is $1,000.

Or I could take that $1,000 and take out a margin loan and have $10,000 to invest and buy 200 shares in XYZ company at $50. Leveraged, simple. Max loss is $10,000.

Alternatively, I could take $1,000 and buy options. XYZ company is trading at $50 while it’s $50 strike price call options are asking for $2.00. In this case you buy 5 contracts of $50 strike call options on XYZ company shares which controls 500 shares. Max loss is $1,000. This is not done with leverage, as no money is borrowed. This is done through a financial instrument which means I do not actually own 500 underlying shares but merely the right to buy these shares at a given price and date. This means I forfeit dividends, voting rights etc. but I accept this inferior product as it allows me to buy more and therefore increase my position size and earn superior returns.

If you do not borrow money then leveraged is not the appropriate way to describe your position. A bet on a horse with 3/1 odds with deliver a return greater than the initial bet, does this mean I have leveraged my bet? The issue here is with the use of your term ā€˜investment’ which is not correct as well. An options contract is a bet, nothing more nothing less as you do not own the underlying asset.

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The term ā€˜leverage’ is commonly misused by people. A product can have an asymmetric risk profile without being leveraged. You can lose more money than you started with without ever touching leverage. The term ā€˜leverage’ only applies to very specific products based on the definition I posted above and should not be used in any other example.

I am not trying to disassociate options trading with risk, I am trying to disassociate options trading with the incorrect assertion that the products are leveraged. It is not appropriate to call an options contract an investment. The motive of profit is not the only requirement for something to be an investment. Otherwise, my example of horse racing betting would qualify as an investment. It does not. I have not invested in an underlying asset or company which grants me claim to profit.

With your example of Brent calls, you are buying them in the expectation of a future rise in value. However, you do not have a claim to an underlying asset or company until you exercise those options. You are betting that you can exercise them at a lower price than the oil is trading at. If I bought the BP shares I would be investing compared to your gambling. That does not mean my investing will produce better returns or is morally superior but they are two different things.

Leverage and high risk do not go hand in hand. I can buy a share which has a higher risk profile than borrowing to buy a house. Yes there is risk in both, but there is not inherently a higher risk in borrowing to buy a house than there is in buying a share. It depends on the house and the share in question. One should always be aware when one sees the term leverage but if the term leverage is not present that does not automatically imply safety either.

I remember reading that Investopedia article at some point or another during discussion with a friend and I don’t agree with the use of the word leverage in it either. By definition, as posted above, it doe snot fit the description.

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You never answered my response to your earlier point so I have nothing to respond to?

You actually did claim that a product must be leveraged to offer asymmetric risk. You stated that if something has the ability to return/lose multiple times the outlay then it is leveraged which is simply untrue. Otherwise asymmetric risk could not exist without leverage.

The difference between owning shares and options is not semantics. Speculation is when you buy something in the hope of being able to sell it to someone else at a higher price. In the example of the Brent options you need the price to rise above the strike price or you do not make a return, in fact if it does not you are certain of a loss. There is no alternative. However, owning a share in a company grants you claims to the profits of that company. The share never needs to be sold as gains can be realised through dividends etc. and so there is no need to sell the share to generate a return.

I agree with the stocks and house example but you missed the point of my comment. My point was leverage does not necessarily equal more risk than something which is not leveraged. The probability of default and the loss given default, in the housing example, could be used to weight the risk and, therefore, the likelihood of loss. There could be shares which you could buy without leverage that have a higher probability of default (let’s assume we infer this from CDS pricing). In that example, leverage does not equal more risk. In fact you could be a greater risk of losing the Ā£50k of shares than than Ā£50k of housing equity. Also in the house example the house retains value and so you would be unlikely to be on the hook for the entire value of the house.

I have not incorrectly policed the term ā€˜leverage’. I have tried to stick to my original comment about the importance of education and try to critique the people who assured me that options trading is leveraged. As you cannot have leverage without borrowing this cannot be true in the case of options.

Leveraged products do expose retail investors to risk but so do traditional products the key is in the risk profile of each individual investment.

@hrochfor1 maybe a good exercise would be to explain to everyone the logistics of money flow for both the seller of the call and the buyer of the put option (in the one transaction) if the option is executed before expiry.

First off, I just want you to acknowledge that by the definition I posted, options are not leveraged? Leverage involves borrowing money.

An option is a contract with contractual obligations which, I agree, can result in the seller of an option being obliged to sell shares to the holder of the opposite side at a widely discounted price to the actual share and this incurring a large loss. This loss could be any infinite of multiples the value of the original contract.

That does not make the product leveraged at all.