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Do Not Underestimate the Robinhood Traders

Traders using Robinhood app were mocked in financial social media for buying Hertz, a bankrupt company. Those “amateurs” were right on the basis of speculation and financial social media once again failed to understand markets.

In financial social media there is little actual understanding of finance and markets.  Although there many competent individuals with credentials, an understanding of finance, economics, statistics and probability, the majority consists of speculators who are looking to make a quick buck by shorting markets. These individuals get upset with any news that is positive for markets, blame the central bank for not letting the economy collapse and constantly accuse the system of manipulation. More importantly, most of these traders are “chartists”: they look at charts although often pretend to talk about finance.

Mocking Robinhood amateur traders – at least this is how they are usually portrayed in social media – for buying the stock of a bankrupt company amid extreme volatility levels shows how even the most outspoken in this group of bears lack understanding of this basic rule of finance:

Upside is unlimited; downside is limited to -100%.

The best speculators in the history of equity markets were longs, not shorts. Let us consider the specific example of Hertz stock (HTZ). Below are charts of daily positive and negative returns from February 24 to June 12, 2020.

It may be seen that in the chart period mean positive return is +24.4% while mean negative return is -11.9%. The difference increased late last month after the sharp rebound in the stock after a collapse. Despite that collapse of -80.5% on May 26, the mean positive daily return is twice as large as the mean negative return. This is because of a streak of large positive returns of +83.8%, +71.3% and +115.2% starting June 4. This means, Robinhood buyers were right and financial social media was wrong.

Let us take this one step further: consider a large group of 20,000 random HTZ traders that used a fair coin to go long HTZ stock if heads showed up at the close of a day and exited when tails showed up at the close of the day, in the same period from February 24 to June 12, 2020. Below are the results of the simulation.

The distribution of total returns of the random traders follows some power law, Minimum return is close to -100% (ruin) but maximum return is more than 888%! This means that some (lucky) random traders using a fair coin could have realized huge returns. On the other hand, the same simulation for short traders (assuming a shortable security) only shows maximum return of about 340%.

Therefore, as the analysis shows, the profit potential was in the long side. Robinhood “amateurs” were right to speculate by buying the stock whereas most of financial social media was wrong and did not see the speculation potential.

In my opinion, a new group of traders has emerged that makes decisions based on different principles than those employed by traditional finance and technical analysis. These traders use some common sense and are bold. Many will be ruined since trading is zero-sum game but some will also make the kind of money that people using traditional methods are incapable of making due to the inherent limitations of their methods and focus on risk management rather than on profit maximization. Risk management is important especially for professionals managing funds but this new group of traders do not seem to be limited by this constraint.

Conclusion: Do not underestimate the Robinhood traders, they play the game with their own rules you may not fully understand.


Charting and backtesting program: Amibroker

Data provider: Norgate Data

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