What is the Stock Market?
Gamestop, Robinhood, and Options Trading...oh my! (10min read)
TL;DR
The stock market is a market for buying and selling ownership in public companies.
Companies sell stock in an initial public offering to raise capital to grow their business, and stock market investors buy, sell, and borrow stocks for profit.
Brokerages make money when you trade, and they make it easy as possible to do so. How financial firms make money drives their decisions. Know the business model of any company you use, especially when it seems "free."
Why Cover the Stock Market?
We hear a lot about the stock market, and no more so than in the last few weeks as the Gamestop saga took over financial news coverage. There's a lot of information on the rise and fall of Gamestop. Here's a solid guide of what happened. In short, Gamestop's stock price increased from $20 to $300 per share in a matter of weeks. Individual (or "retail") investors - using /wallstreetbets on reddit.com to share information and Robinhood.com to trade stock - drove the price increase. Along the way, large hedge funds (notably, Melvin Capital) lost a lot of money, Robinhood had to raise a lot of money, and individual investors both made and lost money! Elon Musk was also involved, but we won't get into that...
In this post, we'll use Gamestop to demonstrate what the stock market does, how works, and why it matters.
What is the Stock Market?
The stock market is a marketplace for buying and selling pieces of ownership - called stock - in publicly traded companies.
The cool thing? Anyone can buy these stocks. Why? Because publicly traded companies are required to share company information publicly and equally with all of their investors.
During an initial public offering, the company sells stock to retail and institutional investors for cash. The company uses that cash ("capital") to grow, and those investors can make money as the company grows (PS - We'll tackle IPOs in depth in our next post.) If a company needs to raise more capital after the IPO, it sells more shares to the public market.
Once a company is public, investor buy shares from other investors in the market, not the company itself. As an owner (“shareholder”), if the company's value grows, the value of your stock grows; if the company's value drops, the value of your stock also drops.
How does the Stock Market Work?
Let's walk through three examples: buying a stock, shorting a stock, and trading stock options.
Buying a Stock:
Buying and selling stock is pretty straightforward. Buying stock makes you an owner of the company, and it's easy to sell stock for cash.
It's October 2020, and you want to buy Gamestop at $10 per share. You saw the news that the founder of Chewy, a successful online retailer, purchased 10% of Gamestop in August 2020, and he may join the board. Even though Gamestop sells video games at retail locations, you believe the company can pivot to distributing games online. As of October 2020, the Gamestop stock price is relatively low, and besides, you used to love going there. You use Fidelity to buy the stock. As a brokerage, Fidelity is legally allowed to buy and sell stocks on your behalf as their customer. You set the price you're willing to pay ("bid") and the timeframe you're willing to wait (say, one trading day or 180 trading days). You can also set a maximum price ("limit"), or take whatever price is available in the market ("market price"). You hit confirm, and you're done!
Now the fun starts! Fidelity sends your order to their automated trading system, which tries to find you the lowest price. If Fidelity is unable to find a seller in their trading system, a market maker, like Citadel, might buy the stock from them and sell it to another customer later. At the end of the day, the Clearinghouse makes sure everyone has their money, including you the investor and Fidelity the broker. It takes two days for money to get to the right place (or to "settle") behind the scenes. In that timeframe, Fidelity has to wait for the money, even though they’ve already put the stock or dollars in your account.
Shorting a Stock:
Shorting a stock is a way to make money when the stock price goes down.
It's November 2020. You are certain Gamestop's stock price will go down. You've notice the price almost double since July 2020, and you aren't sure Gamestop can capitalize on digital games. You decide to short the stock. (Your name may or may not be named Melvin Capital...)
Shorting a stock is like a game of hot potato.
You're technically borrowing the stock for a short period of time in order to make money on the difference between the price you borrowed the stock and sold the stock.
You tell your brokerage to borrow a share of Gamestop at the market price of $10 per share for one month. The brokerage lends you the stock at that price plus interest. Remember - you think the price is going down. With the borrowed stock in hand, you sell the stock to another investor for $10. Once you've found a buyer, you need to return the stock to the original investor within the specified timeframe. Ideally, the price has dropped - say to $7. You buy the $7 stock and return it to the original investor. If the price of the stock has gone down, you just made money about $3 on the price difference. [$10-($7+ interest)]
But, if the price of the stock goes up - say to $17, you've lost the difference (plus the interest!). What if the stock goes even higher? Say, to $300, like Gamestop did in January? There's no limit to how much you can lose in short selling, because there is no limit to how high a stock can go. This is how Melvin Capital lost billions of dollars. They didn't just borrow one stock they borrowed millions. All of this makes their losses and gains amplified.
Options Trading:
Instead of buying Gamestop stock, you decide to buy options.
Options aren't ownership of a company. They are a contract between two investors that give you the right buy or sell the stock at a future date with a price set today.
Why use options? Options are less expensive than stocks, offer plenty of upside, and are often free to trade. For expert traders, there's plenty of strategies you can use to profit from options trading. (For what it's worth, options trading is not my expertise. I'm more of a "set and it forget it" investor.)
On Robinhood, you buy a call ("right to buy") option. It's January 2021, and the stock price has risen significantly in that last few weeks. A lot of investors in an online forum /wallstreetbets are saying to buy the stock, and Elon Must tweeted about it. You pay $60 for the option to buy shares of Gamestock if the stock reaches $100 per share. The stock rises to $300. You have a contact that says you can buy the stock at a $300 value for just $100! You've made $140 dollars [($300-($100+$60)].
Brokerages, like Robinhood, lend capital to investors for options trading. Robinhood makes money on these loans. It's one reason they don't charge you a fee each time you trade. Robinhood, as a broker, needs to have enough cash for these loans. When Robinhood, and other brokerages, halted Gamestop trading in January, they didn't have enough cash for the trades on their platform, both because of these loans and because it takes days for Robinhood to receive money.
Why does the Stock Market Matter?
The stock market is an incredibly powerful tool to invest in and profit from high growth, public companies. Ownership is the way to build wealth in a capitalist society, and new tools have lowered the barrier to entry and broadened access to the markets.
At the same time, if the stock market feels more like short term gambling than long term investing, you're not alone.
Why? It's pretty simple.
Brokerages make money when their customers trade. They loan you money so you trade. They sell your trading data to market makers so you trade. They don't care if you build wealth or if your portfolio grows. They do, but only if you trade. It is so easy to trade that the market has become more about short term bets than long term investment. Robinhood just happens to be the best example because they're so damn good at it.
Fundamentally, market incentives make short term trades more compelling than long term investments, especially for retail investors using. If we want to fulfill the goals of allowing everyone to access market growth and companies to access capital, we have to shift stock market incentives to make it more compelling, and profitable, to hold stocks for the long term. Not just to trade.
Additional Resources:
NPR Your Brain on Retail Trading
Quick note! Any changes made after the original post are in italics in an effort to learn out loud with honesty.