Commentary on Political Economy

Friday, 11 December 2020

FIRE-EATERS WILL GET BURNED

 

When the Stock Market Is Too Much Fun

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Technology can make investing easy and fun. It can also downplay risk in ways that may lead novices astray.

In last week’s column, I described my experience on the popular Robinhood brokerage app, especially how trading became hard to stop once I started. Now let’s look at how Robinhood may encourage risky behaviors that could backfire.

Illustration: Alex Nabaum

Consider some exchange-traded funds. Leveraged ETFs magnify the daily return of a market index, typically doubling or tripling it. Inverse ETFs deliver the opposite of a market’s one-day return, often amplifying that gain or loss with leverage. Volatility ETFs are a pure play on the short-term fluctuations of stocks or other assets.

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Such funds are fireballs that can heat up a portfolio—or scorch it. ProShares UltraPro QQQ, or TQQQ, seeks to deliver three times the daily return of the Nasdaq-100 index. It gained 35% in November. During the February-March market panic, it lost 70%.

The Financial Industry Regulatory Authority, or Finra, which oversees brokerage firms, has warned these ETFs “typically are unsuitable for retail investors who plan to hold them for longer than one trading session.”

Over the yearsI’ve written repeatedly that leveraged ETFs aren’t appropriate for most investors. In my trading experiment on Robinhood, however, my goal was to make as much as possible as fast as possible, so I was willing to play with fire.

Try buying a leveraged or inverse ETF at Fidelity.com and a pop-up says you can’t unless your investment objective is “Most Aggressive.” You must also attest that you’re “a sophisticated, experienced investor.” Charles Schwab has similar restrictions. At Vanguard.com, you can’t buy leveraged and inverse ETFs at all.

On Robinhood, these explosive funds are as accessible as any stock.

I bought TQQQ on Oct. 27. Robinhood gave me no prominent warning that it was unusually risky and, in notifying me that my buy order was complete, asked if I wanted to “Set Up Recurring Investment” in the fund.

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Three days later, I bought ProShares UltraPro Short QQQ, a leveraged ETF that seeks to triple the inverse of the daily return of the Nasdaq-100 index. This time Robinhood urged me to “Build Your Portfolio Over Time...by turning this into a recurring investment.”

Robinhood says these displays were generated automatically as part of a campaign to encourage customers to build wealth for the long run. The firm says it doesn’t permit customers to make recurring investments into leveraged and inverse ETFs.

Before the market opened on Nov. 4, my phone lit up with a “Robinhood | Siri Suggestion” to “View VIXY,” a volatility ETF I’d sold two days before.

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It’s lucky I didn’t view it—or buy it. VIXY dropped 8.8% that day and fell another 15% over the five days after that.

Robinhood says its price alerts go out when a current holding, or a former holding on a watch list, moves 5%. Users can change that setting.

Such alerts on risky ETFs could be problematic, says Tom Selman, a former senior executive at Finra and founder of Scopus Financial Group, a regulatory consulting firm.

“These are complex products, and unless the communication offers full and fair explanation of the facts about them, then retail investors can be misled,” he says.

“We don’t believe price alerts based on a customer’s prior investment requires a recitation of risks and benefits of an investment,” says a Robinhood spokeswoman. A general disclosure about ETFs on Robinhood says leveraged funds “may not be suitable for all investors and may increase exposure to volatility.”

Meanwhile, Robinhood’s emails and other communications were prompting me to trade options, another risky strategy I’d signed up to try.

I didn’t trade any, largely because the way Robinhood displays options prices confused me.

Other brokers show your potential gain and loss equally prominently. When you look into buying a call option on Robinhood, however, the app shows you a measure called “To break even,” with no indication of potential loss.

Interested in selling the same option? Now Robinhood will show you something called “Chance of profit,” again with no measure of possible loss.

But if there is (say) a 65% chance of profit if you sell an option, then there must be a 65% chance of loss if you buy it. By instead highlighting “To break even,” Robinhood draws your attention to how little a stock has to rise for you to begin making money by buying an option—even though you could lose as much as 100% of your investment if the stock goes up less than you anticipated (or goes down).

“Chance of profit,” meanwhile, focuses you on the high likelihood of earning at least a small amount when you sell a call option. If the underlying stock goes up more than you expected, though, that could cost you far more in forgone upside than you earned selling the option.

Other major brokers, including ETrade, Fidelity Investments and Charles Schwab, don’t pull this sort of switcheroo. They use the same format whether you want to buy an option or sell it—and they don’t use the term “Chance of Profit.”

“How a brokerage firm displays risk and reward shouldn’t hinge upon whether you’re buying or selling an option,” says Roy Haya, head of options strategies at Fort Point Capital Partners LLC, a San Francisco-based investment firm. “Changing the optics like this could encourage activity on both sides of the same trade, and that seems like a suspect way to entice inexperienced options traders.”

“Each [options-quote] display,” says a Robinhood spokeswoman, “seeks to elevate the information that we have found to be most relevant to a seller or a buyer, who have asymmetric opportunities and risks—certainly not to encourage any particular investment strategy.”

Like many brokerages, Robinhood earns a small payment when it directs customers’ trades to particular firms that fill buy and sell orders. In September alone, Robinhood earned $42 million on such options fees, more than twice what it earned from all stock trades combined, according to a disclosure from the firm.

Robinhood says about 13% of its customers who trade in a given month use options, and they must hold the underlying stock when selling a call option, which tends to limit losses.

Robinhood has become so popular largely because it helps get new investors started by making the stock market feel fun and engaging. How Robinhood presents risky ETFs and options, however, makes me wonder whether it has created a game in which many of the most vulnerable players may end up being played.

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