Just two days after Charlie Munger of Berkshire Hathaway called Robinhood “a gambling parlor,” the free-trading app said it derives a majority of its revenue from options trading.
The comments from Warren Buffett’s right-hand man came in an interview with CNBC on Tuesday night, in which the billionaire investor said, “it’s telling people they aren’t paying commissions when the commissions are simply disguised in the trading.”
On Thursday, Robinhood filed its S-1 with the SEC, a necessary step the company has to take prior to going public. The document revealed the underlying drivers of Robinhood’s business, from options, equities, and crypto trading, to securities lending and payment for order flow.
In 2020, Robinhood generated $720 million in revenue, of which 61%, or $440 million, was derived from options trading. Robinhood’s options trading revenue grew 298% in 2020, relative to 2019, as the pandemic and government stimulus checks led to a boom in stock market trading by retail investors.
Options trading is often viewed as a much riskier form of trading relative to stock trading, as it gives investors leverage to increase their exposure to short-term or long-term moves in the stock market.
While less risky option trading strategies exist, like selling covered calls on an underlying stock holding, a bulk of the options trading among Reddit “YOLO” investors tends to be buying directional put or call options with short-term expiration dates. Unless timed properly, these types of options trades can lead to a loss of nearly all invested capital.
“[Robinhood is] a gambling parlor masquerading as a respectable business,” Munger said.
Robinhood probably disagrees with Munger. In the company’s S-1 filing, it laid out how it’s democratized stock market investing for 18 million users through $0 trading commissions, an easy-to-use app, and education initiatives.
The company said more than 50% of its customers say they are first-time investors.
A customer named Angelina was quoted in Robinhood’s S-1 as saying, “The investor in my head was someone who wore a suit and a tie. Robinhood changed that for me.”
Hedge fund Mudrick Capital lost 10% in just a few days of trading as shares of meme stock AMC Entertainment spiked to record highs, the Wall Street Journal reported, citing people familiar with the matter.
The losses were driven by call options sold by firm founder Jason Mudrick, according to the WSJ. The position, intended to serve as a downside hedge, ended up backfiring as the stock surged too much, too fast.
The runaway share spike occurred on June 2, when AMC shares rose as much as 127%, to $72.62, well beyond the strike price of $40 for Mudrick’s options.
Just one day prior, Mudrick had disclosed a $230.5 million purchase of new AMC stock, then immediately sold those shares at a profit, according to a Bloomberg report. Despite the success of that leg of the overall AMC trade, Mudrick’s calls on the stock were still held short, leaving them vulnerable to the June 2 surge, the WSJ found.
Mudrick did close out all options and debt positions on June 2, albeit too late to avoid the squeeze. While the fund did earn a roughly 5% return on the debt, it ended up absorbing a net loss of 5.4% because of the options trade.
Though the fund took a hit amid the surge, it’s still up about 12% for the year, the Journal said. Meanwhile, AMC, the world’s largest movie theater chain, is up more than 2,000% year-to-date.
Retail traders have been dealing blows to short sellers and hedge funds this year as they’ve poured into stocks with high short interest rates in order to force a short squeeze. Earlier this year, investors on Reddit’s Wall Street Bets led a share price surge in GameStop, which caused short sellers to lose billions.
Amid the renewed meme-stock interest in recent weeks, short sellers have continued to lose money in retail-trader favorites like AMC and GameStop. The meme stock trade has scared off many short sellers from heavily betting against certain stocks.
A long position in investing basically means to buy or own a stock. Generally, you do so because you expect it to increase in value in the future – hence, you’re holding it for the long-term.
But a long position also has a specialized meaning, having to do with options and options trading. It refers to buying a specific kind of option, based on your belief as to where the price of a stock (or another asset) is headed.
Let’s examine how a long position in options, or “going long” as the traders say, works.
What is a long position in options?
In the options-trading world, taking a long position, or going long, means you’re purchasing an option. An option is a contract that gives you the right to buy or to sell shares for a preset price (or “strike price”) on or before a future date, usually within the next nine months. It’s an opportunity to do this trade, but not a commitment – so, an option.
There are two types of long options, a long call and a long put.
A long call option gives you the right to buy, or call, shares of a named stock for a preset price at a later date.
A long put option does the opposite: It gives you the right to sell, or put, shares of that stock in the future for a preset price.
How a long call option works
If you believe a certain stock is going to go up in price in the coming days, weeks, or months, you can purchase a long call option to buy that stock for today’s price sometime in the future and make a profit by selling it on the stock market at the then- higher price.
Example: You believe ABC stock, selling today for $100 a share is going to be worth more in a couple of months. You purchase a long call option contract for 100 shares, set to expire in three months, at a strike price (a preset price) of $100 per share, and a premium (fee) of $3 per share for the option itself.
ABC does as you expect and in two months shares are worth $150 apiece. You exercise your option, buy 100 shares at $100 each, sell them for $150 each, and you’ve made a tidy profit of $4,700.
How a long put option works
If you believe a company’s stock is due for a drop, you would purchase a long put option contract giving you the right to sell shares of that stock in the future for today’s (higher) price.
Example: You believe ABC is going to decline in a couple of months. You purchase a long put option contract for 100 shares, set to expire in three months, with a strike price of $100 per share, and a premium of $3 per share.
ABC does as you expected and in two months shares are selling for $50. You buy 100 shares at $50 each, exercise your option, and sell them for $100 each, and you’ve made a tidy profit of $4,700.
Exercising your long call or long put option
Whether you buy a long call or a long put, you can’t make money unless you exercise your option. Exercising your option means to buy or sell before the expiration date set in the option contract.
Naturally, you’d exercise the option if things go the way you expect – the stock moves in the manner you thought it would, so you get to buy it (with a call) or sell it (with a put) at a price that’s better than the current market rate.
Why would you let the option expire without exercising it? Simple: The price of the stock goes against your prediction, moving in an opposite direction from the strike price. If that happens, the option becomes worthless. You let it expire, and you lose the premium you paid.
The good news is, that’s all you lose.
Why take a long position in options?
Going long lets you take chances with less risk. Both long calls and long puts limit your loss to the premium, the cost of the options contract. You don’t have to buy the stock (in a call) or sell the stock (in a put) unless you expect to profit – by the shares moving as you anticipated before the contract ends.
In contrast, in regular investing, you’re committed to an actual purchase. And that could cause you to lose a lot of money if the stock doesn’t move in the direction you expected.
In addition to being less risky, long options also include an unlimited profit potential to the upside in the case of a long call option or the downside with a long put option. As long as the stock is above or below your option’s strike price – for the call or the put, respectively – you stand to win.
Both types of options are considered long, in the sense that both are buy positions and both let you make money on the direction of the underlying stock. However, the long call is the more bullish sentiment, because you’re betting that the stock price will rise.
The long put option is a more bearish view because you’re anticipating, and hoping to profit from, a fall in the stock price.
A long put option can also serve as a hedge, or insurance, against a bad outcome with a long call option or an outright purchase of stock. Yes, you’re betting against yourself, in a way, but at least you stand to benefit a bit if the stock falls instead of rises, mitigating your overall loss.
The financial takeaway
With options, going long refers to a position in which you buy:
a long call option, meaning that you expect the underlying asset to increase in price, which increases the value of the option. This option is bullish on both the underlying stock and the option itself.
a long put option, meaning you expect the underlying asset to decline in price, which increases the value of the put option. A long put option is bearish on the underlying stock but bullish on the outcome of the option.
Long option positions require less investment, or cash down, than outright investments. Instead of spending thousands on a stock, you just spend a few hundred on the option, giving you more leverage for less money.
Of the two options, long calls are more common – or at least, what’s more commonly thought of as a long options position. And, like buying stock outright, they are essentially optimistic. Long puts, pessimistic bets that a stock will fall, are more often used as insurance against a bad outcome with a long call, or with an actual ownership position.
But in a way, both long options can be considered bullish: Both are buy positions, affording you a chance to make money on the moves of the underlying stock.
One Robinhood user in Massachusetts made an eye-popping 12,748 trades since February, according to the state’s complaint, which alleges the popular investing app encouraged inexperienced investors to execute trades frequently.
The complaint against Robinhood was filed on Wednesday and also detailed how the brokerage firm popular among younger investors failed to supervise the review and approval of options tradings, leading to many inexperienced traders dabbling in more complex investments.
In an e-mailed statement, Robinhood said, “We disagree with the allegations in the complaint by the Massachusetts Securities Division and intend to defend the company vigorously.”
Robinhood’s rapid growth and lack of internal controls facilitated an environment where inexperienced investors would trade stocks and options incessantly, nearly 100 times per day on average in one case, the state of Massachusetts said in a complaint filed on Wednesday.
The complaint is separate from a settlement with the Securities and Exchange Commission announced on Thursday that resulted in Robinhood paying $65 million to settle charges of misleading clients on the quality of its trading service.
According to Massachusetts, Robinhood successfully encouraged inexperienced investors to execute trades frequently on its platform by utilizing gamification techniques.
“During the relevant time period, at least 241 Robinhood customers with no investment experience averaged at least 5 trades per day on Robinhood’s platform,” the complaint said.
An average of five trades per day is peanuts relative to 25 Massachusetts Robinhood customers detailed in the complaint.
“Robinhood experienced as many as seventy outages or disruptions on its trading platform from January 1, 2020 through November 30, 2020 as a result of its failures,” the complaint said. At least seven of those disruptions impacted the ability of Robinhood customers to access their accounts to buy or sell securities.
Four more allegations against Robinhood listed in the complaint include: advertising to younger individuals with little to no investment experience, providing lists to encourage customers to purchase securities without consideration for suitability, employing a number of strategies to encourage customers to continuously engage with its application, and failing to meet the fiduciary duty it owes its customers.
In an e-mailed statement, Robinhood said:
“We disagree with the allegations in the complaint by the Massachusetts Securities Division and intend to defend the company vigorously. Robinhood is a self-directed broker-dealer and we do not make investment recommendations. Over the past several months, we’ve worked diligently to ensure our systems scale and are available when people need them. We’ve also made significant improvements to our options offering, adding safeguards and enhanced educational materials. Millions of people have made their first investments through Robinhood, and we remain continuously focused on serving them.”
Robinhood is likely hoping for a swift resolution to the complaint as it plans to go public next year at a valuation of more than $20 billion, according to reports.