Robinhood Traders Discovered a Glitch That Gave Them ‘Infinite Leverage’ | Hacker News Reader

Robinhood Traders Discovered a Glitch That Gave Them ‘Infinite Leverage’

bloomberg.com

583 pointsgaleos324 comments

The person that posted the $1M position using $4K (https://www.reddit.com/r/wallstreetbets/comments/drqaro/robi...) hasn't said that Robinhood has shut him down yet, which is crazy to think.

Ultimately Robinhood screwed up, so I don't know if they really want to expose themselves any further by trying to go to court with any of these people. That would do more damage to their reputation/valuation than resolving these cases as quickly and amicably as possible.

I personally can't believe this is still unresolved, though. The original $50k Apple puts guy uploaded the video last week, and these copycats were still able to exploit the issue. As on right now, I don't think it's yet fixed. Why didn't Robinhood fix the bug over the weekend? Why aren't they treating this like a massive legal issue/regulatory violation? It's so strange.

IANAL but I assume offering unlimited leverage to retail investors is also illegal or at least against SEC guidelines. Besides, if I was insuring RH right now I would be talking about increasing premiums.

No need to increase premiums unless RH has a claim that's covered by their policy. "lol we give away money to whoever asks for it" might well be excluded.

According to some random person on the subreddit who probably isn't a good source, the SEC limit for leverage for normal people is 2:1.

2:1 is correct. Or 1:1, depending on your definition of "normal people". The relevant rule is called Reg T and it's not a limit set by the SEC, but by the Federal Reserve.

I was taught that some aspects of that rule go back to the stock market crash of ‘29. There were few limits on leverage then, either.

This correct. My knowledge comes from +15 years working in finance. I dont know the individual limit on leverage, bit its fairly low. Institutionally is another story.

I was working at a fairly large hedge fund through the 2008 collapse that saw a huge loss due to a 40:1 leverage. Nearly bankrupted the firm. Through September and October, the lot of us working there thought we were doomed and were awaiting the layoffs that never came. As a result, the firm put in a self imposed leverage limit of 10:1 amd divested itself of less liquid assets like bank loans. We held around $20B USD in bank debt that was toxic and couldnt find a market for. No bailout, but something like 60% of $24B USD evaporated in a month. It was all made back in about 18-24 months, though. Crazy times...

Is your full story written up somewhere?

I have no idea if SEC guidelines limit the amount of unsecured buying power offered to consumers but it does not follow from any such stipulated guideline that a bug in an order entry system shifts liability to RH from its customers. All applications – including other order entry systems – have bugs like these.

Most regulatory organizations such as SEC enforce "means", rather than "results". In simple terms: You will not have problems if a bug happens, as long as you can show that you had a reasonable, best of your knowledge, process to avoid bugs (code review, staging changes, fallback plans, regular analysis/checks, etc).

This does not seem to be the case for RH unfortunately. They will have to explain why the detection / escalation failed for this issue, why no statements were provided, why it was not spotted by internal analytics/checks, why the pre-trade checks let these trades go, etc. They will probably end up with a huge fine.

Disclaimer: I work in a hedge fund that is SFC regulated. I expect the SEC to have pretty much the same policies.

It sure is. In The Reddit thread on wallstreetbets someone already submitted an official complaint because you get a commission!

Yes, that this bug has existed so long after it was used and publicized is scary. If it goes on too long, Robinhood becomes insolvent because they absorb the losses but pass the winnings on to their customers.

Which leads me to believe this has already happened and Robinhood is falling apart organizationally as they realize they don't have enough money to cash everyone out. Which in turn means they need to keep it quiet or else there will be a "run on the bank".

Taking this line of thinking a bit further, they may have been trying to get more money from investors, and if they haven't already, now these stories are out they might not be able to. So I wouldn't be surprised if Robinhood freezes all accounts over the next week, and the SIPC gets involved.

What SIPC does: https://www.sipc.org/for-investors/what-sipc-protects And thankfully Robinhood Financial LLC of Menlo Park CA is a member: https://www.sipc.org/list-of-members/R

I would assume there is almost no one with over $500,000 using Robinhood, but if so, you better get your money out now.

They just raised 50 million dollars a week ago according to crunchbase [0] and I doubt they have blown through that already.

[0]: https://www.crunchbase.com/funding_round/robinhood-series-e-...

It takes only 50 customers like the guy above to loose their money to some ill-conceived put option.

Considering the posters of /r/wallstreetbets have a leader board going to see who can glitch the most leverage, it's well within the realm of possibility

https://old.reddit.com/r/wallstreetbets/comments/drt5tr/guh_...

Unless I've missed something, it would only require 1 customer with a serious risk appetite.

I believe the phrase is a high "Personal Risk Tolerance"

Robinhood has changed their app several times based on users finding various bugs and workarounds that affected the trades they can place.

Another famous case is user "1ronyman" who opened up a massive options spread that had a potential loss of $500k which was 50x bigger than his account [1]. Proper risk calculations would never let him make the trade in the first place but Robinhood did and likely had to take the loss.

It shows the dangers of playing fast and loose as a "tech company" in heavily regulated and complex environments like fintech.

1. https://www.reddit.com/r/explainlikeimfive/comments/ah578l/e...

1ronyman said just today that he isn't going to pay RH anything. They haven't forced him to do so at all.

He went from $250,000 to $50,000 in debt and as I said, isn't going to pay anything (as far as I know).

Would you mind linking to that? Thanks

https://www.reddit.com/r/wallstreetbets/comments/dq9hiv/week...

>If it goes on too long, Robinhood becomes insolvent because they absorb the losses but pass the winnings on to their customers.

Companies rarely absorb losses due to "abuse" by their users. Even when it is entirely the fault of the corp. I'm sure they have small print somewhere that absolves them of all responsibility for trades that do not meet some arbitrary guidelines.

It would likely require a class action lawsuit by the users, and get dragged out for years. They have more to worry about from the SEC on this then paying their users, if history is a predictor for this.

Where exactly do you think the money is going to come from? These people are taking $2k and making trades that are losing $500k. They never had $500k. Robinhood is still out of that money, regardless of their guilt or whether they are convicted/sued/etc. There is no money to chase after. That's why this sort of thing is so insane.

What happens in a normal brokerage when someone, despite the brokerage’s risk management checks, manages to get a margin deficiency that they cannot possibly rectify by liquidating their holdings or depositing cash? Serious non-rhetorical question, I have no idea...

Credit loss.

Brokerages are exposed to a lot less of it than e.g. credit cards, because it isn't baked into the model in the same way (and, indeed, the opposite is baked into the model), but it has been known to happen. See the Interactive Brokers 2018 annual report:

Over an extended period in 2018, a small number of the Company’s brokerage customers had taken relatively large positions in a security listed on a major U.S. exchange. The Company extended margin loans against the security at a conservatively high collateral requirement. In December 2018, within a very short timeframe, this security lost a substantial amount of its value. The customer accounts were well margined and at December 31, 2018 they had incurred losses but had not fallen into any deficits. Margin shortfalls were met in a timely manner by delivery of additional shares by the customers. Subsequent price declines in the stock have caused these accounts to fall into deficits, despite the Company’s efforts to liquidate the customers’ positions. Through February 27, 2019, the Company has recognized an aggregate loss of approximately $47 million. The maximum aggregate loss, which would occur if the securities’ prices all fell to zero and none of the debts were collected, would be approximately $59 million. The Company is currently evaluating pursuing the collection of the debts.

"Whose money did IKBR lose?" IKBR's. (Mechanically, it's a hit to their shareholder equity, which you can verify with toy math if you like playing balance sheet games.)

"What stock was that?" A Chinese firm with no operations which reverse-merged with a NASDAQ-listed entity to do a pump-and-dump. https://www.bloomberg.com/news/articles/2019-04-29/china-fir... c.f. https://hindenburgresearch.com/yangtze-river-port-logistics-...

They’ll probably face criminal charges but that won’t help recover the money.

Collection agency. They'll get something, and probably most of what the customer has.

Presumably you don't pull shenanigans like this if you actually have any savings to lose.

https://www.nolo.com/legal-encyclopedia/what-does-judgment-p...

The more interesting question here is what Robinhood’s clearing house is exposed to. It’s been a while since I looked but they don’t clear themselves and the clearing house may have had exposure.

If that’s the case you can expect the relationship to change. Robinhood will either lose some capabilities or will pay more for clearing.

Looks like Robinhood is now Robinhood's clearing broker: https://robinhood.com/support/articles/360001397126/whats-cl...

Literally they go out of business. Best example is Barings Bank:

"The bank collapsed in 1995 after suffering losses of £827 million (£1.6 billion today) resulting from fraudulent investments, primarily in futures contracts, conducted by its employee Nick Leeson, working at its office in Singapore. "

https://en.wikipedia.org/wiki/Barings_Bank

Not quite the same situation, but your point is still valid.

Leeson was hiding losses fraudulently in error accounts as a malicious internal actor.

In these cases, clients are being extended credit they likely cannot underwrite, leaving RH exposed and liable to any losses theirselves.

On Jan 15, 2015 (aka Black Thursday), the Swiss National Bank unexpectedly floated the Swiss Franc. Some major, well funded brokerages nearly failed as a result of the huge price movements -- their small customers who made a profit kept the profits, but too many small customers ended up with negative balances, the brokerages couldn't practically recover the losses.

Sounds like the old your problem vs bank's problem joke, only with smaller amounts because RH isn't Goldman.

I don't understand why this would be at all difficult for RH to go after. It's clearly fraud. The WallStreetBets top comments seem to have this pretty much dialed in: the best case is that RH unwinds the profits you make; the worst case is, well, much worse.

Because RH is on the hook, immediately, for any losses their users may have incurred. Any reparations they might get from their users would have to be collected individually, through a lengthy legal process, from people who are likely unable to pay.

I wonder if they can actually bust the trades here? That feels unlikely to me. (I don’t know enough about contractual remedies to speculate on whether they can just keep the money in the “flip lands in user’s favor” case.)

Peanut gallery: “Bust trade” has a technical meaning, to tell the counterparty that the trade was in error and pretend it never happened. There are limited circumstances where this is possible. This is different from e.g. “We’re force liquidating these positions.”

No chance at this point, traders might have a non-zero risk of a fraud charge of some sort since they are purposefully misrepresenting the value of their account in order to get credit but RH is going to get stuck with the vast majority of the bill.

I think a broker or marketmaker has in the order of minutes to bust a trade that is "clearly erroneous" and it has to be immediately reported. The exact time period varies by exchange but for example for nasdaq it's 30mins for some trades and 60mins for others https://nasdaqtrader.com/Trader.aspx?id=ClearlyErroneous For the exchanges I'm more familiar with (in Europe) it's less.

The criteria for clearly erroneous trades are incorrect price, size or security though so I don't think this would qualify.

Most likely scenario here is that there is an investigation into fraud and that any gains here get forfeit but users are still required to make good any losses. Separately I would expect RobinHood gets a hefty fine as well.

I don't know, they shouldn't sue them simply for taking advantage of the exploit, these users did knowingly take on leverage by borrowing money to do so. The standard practice when taking on leverage is that you owe the money one way or another. Saying that Robinhood wouldn't have want to give them that leverage, but did give it to them, doesn't really change the legal obligation to make good on a debt willingly and knowingly incurred.

Exactly, these folks will be waiting 7 years for their credit to not be obliterated and maybe they might have to wait for some of that in federal prison. What the heck are they thinking?

People at the Department of Justice are archiving all these reddit posts. It's pure self-incrimination. The screenshots can be easily tied back to their Robinhood accounts. They won't be getting any easy plea deals. It's a question of whether Robinhood will press charges or not.

You always get a plea deal. It's just the terms won't be as favorable.

What would that charges be though? What crime is broken when a trader takes on debt that Robinhood inadvertently allowed?

I withdrew all cash from Robinhood and urged everyone to do the same. Funds are not safe. Brokerage accounts are insured by SIPC (similar to FDIC), but you don't want to wait N months to get reimbursed after whatever lengthy court battles are about to go down.

Withdrawing cash is the easy part. Moving the stocks to another brokerage seems like a pain. and I fed don’t want to liquidate my positions for tax purposes

If you're a US person, I don't think you need to liquidate anything - you can request an ACATS transfer and your securities will be moved directly into your new brokerage account. This is a service run by the NSCC so I think would apply to all brokerage firms.

If someone commits securities fraud I don't think robinhood is the one who has to take them to court, isn't that handled by third parties that will involve themselves regardless of whether or not robinhood wants them to?

As ridiculous as all of this is, there's some poetry in a company called Robinhood taking angel investment from various billionaires and using it to give millions of dollars in (probably) free leverage to teenagers.

But the real recipients of the money are the traders (hedge funds, market makers, etc) on the other side of the transaction.

So, it's a cash flow of billionaires -> teenager margin account -> billionaires.

"He stole from the rich, and he gave... Well, he airdropped the money over a gated billionaire neighbourhood." doesn't make the most catchy song for a folk hero.

Eh, if I did this and I came up in the black off on a play with $1M in free leverage I would just close the position, pay off the margin and dip without posting about it. If like five people posted about it and lost money, there are probably a couple winners who are lying low, even just completely randomly assuming the traders have absolutely no signal whatsoever in their choice of play.

But in that case, since the margin was returned, RobinHood, or its investors didn't lose anything. So, the analogy still doesn't hold. :)

You're not understanding the math here.

RobinHood is essentially lending unlimited money to the teenagers in question. Assume, as an oversimplification, half of them will win big, and half of them will lose it all.

For the wins, the teenagers will keep it all, and for the losses, RobinHood will have to pay for it, because the teenagers don't have the money and will declare bankruptcy if RobinHood tries to recover it. This is a net wealth transfer from RobinHood to the teenagers.

The net wealth transfer looks like this:

teenagers: +lots of money

traders on the other side of the transactions: approximately +0 (wins and losses cancel out)

RobinHood: -lots of money

You can play games with which money comes from where, but you can't deny the way the money is flowing on net.

Most people would keep doing it until they lose it all. The original guy who lost $50k was at one point up net +$20k but still didn't close out.

Market makers don't take money from people. They are on the end of literally every stock market transaction.

Sure they do. Not in bulk quantities, they take their profits on trading the spread. A lot of trades that they generally only make about a cent per share on each trade.

Market makers have their place, and you wouldnt have the liquidity you'd like if they weren't there. Market makers face relatively low risk as they dont generally hold positions for long, but they can also face severe penalties if theyre supposed to be in the market, but are not. My first boss was fired over a potential $600K USD fine because he took us out of the Options market (as a market maker) for an hour (potential fine was $10K/minute) and refused to accept accountability for his actions.

Also, trades are typically matched on a first in, first out basis with price/time priority. Market makers respond to messages that are essentially a request for liquidity if an appropriate contra order is not sitting on the exchange's order book.

Who gets paid commissions depends on what type of entity is on the other side of the trade and what agreements are in place with the meriad of counterparties involved (e.g. if you want to buy 10K shares of a company, that could be broken into, say, 20 trades of various quantities and prices below a limit until the quantity is fulfilled).

Only if they lost in the trades. (Most of them probably did.) If they won, then they truly robbed from the billionaires. They risked billionaire VC money (Robinhood's underwriting fund) to take money from some other billionaire investor's bad trade.

"...even if you can do this, it’s not ... it’s not like it’s free money or anything. You get more leverage than you ought to, but why would you want infinite leverage? "

Because you either win huge, say $10M with ~ 50% chance, or go bankrupt, which is a good proposition for people who have very little to lose.

But have people won big, or have they just been losing their modest initial stake?

If you only have a few hundred or thousand to start with, you can gloat about how you only really lost that much while theoretically owing millions, but you still gave up 100%.

Do Robinhood users typically have nothing to lose?

It will be interesting to see if Robinhood will go after (i.e., pursue claims in court) teenagers who get carried away and rack up $50k+ deficits from this. The article links to a Youtube video of a young person watching their account (which they used this bug to accumulate a $50k+ position in Apple puts right before they beat earnings recently) evaporate in front of their eyes, going deep into negative territory. Even though Robinhood has a good legal claim here, it would be very bad PR for people to start thinking that they can lose a lot more than they put into their accounts. Bad enough that you can lose all of that in the blink of an eye with margin trading, but it should be impossible to mortgage your whole future that way!

Even if Robinhood goes after them, they don’t have any assets or money. Unless there are criminal charges (which there might be), what could actually happen?

They could win a legal judgement that might not be able to be discharged in bankruptcy. Even if they can't pay it now, they might have their wages garnished in the future until it is repaid. Also, if they are minors, their parents might pay it to avoid their kid's credit being ruined for decades because of bankruptcy.

bankruptcy should only be on your record for 7-10 years. And a minor can't be held accountable to any kind of contract. I would think that first, RobinHood would be outta luck. Secondly, the kid. Lastly, the parent. As a parent, I would tell my kid "sorry bucko, you don't get to buy a car for the next decade."

Bankruptcy is not as bad as everyone makes it out to be. You can get an FHA mortgage 1-2 years (depending on circumstances) after the discharge date. You can get a non-QM (not Fannie/Freddie/FHA backed) loan the next day at a higher interest rate (~200-300 basis points above prime), which you're only going to carry for two years until you can FHA refi. You'll get a secured credit card. You'll pay more for an auto loan. But you'll get credit nevertheless because you can't go BK again for another 7 years. You will pay more for that credit, but you will still get it. Walking away from certain levels of dischargeable debt is entirely reasonable. That is why we have bankruptcy as a financial tool.

Some states are better about protections against creditors than others. Don't live in a state with poor creditor protections (Florida is fantastic, Missouri is terrible).

don't forget prosper and lending club. although non-QM loans generally require 20-30% down.

200-300 basis-points means 2-3% (for the non-finance types).

So your 6% loan is now a 9% loan.

Prime mortgages hover around ~3-4.5% currently. Non-QM is ~5.5-8 percent, looking at a non-QM lender's rate sheet right now (dependent on loan to value, assets, and income). So about what you'd pay for a HELOC or higher rate home equity loan. Even with garbage credit you're not paying 9% on a property that you've got some equity in, but you're not getting a mortgage with only 3% down (nor should you; go rent for a year or two with a landlord who will report positive payment activity to CRAs and then go get your federally backed FHA loan with only 3% down).

I was just using 6 & 9 as example values from the ether (maybe Hendrix) - not in reference to any specific loan type.

And yes, Prime is low today.

Also, if you can make a play for real property: buy dirt. It's a good financial play to build equity/wealth.

An 18 year old isn't getting a mortgage. They probably won't be able to afford a home for the next 7 years anyway. They might have a rough time getting a reasonable car loan and opt to instead buy a used car with cash, but that isn't the end of the world.

Making a high risk play and maybe going bankrupt at 18 might even be a dominant strategy.

I never used credit from 18-25 aside from churning some credit cards.

It sounds to me like this is the dominant strategy for many people who dont use the traditional credit system much and are young and have no assets. You get a 1 in 20 chance of a million dollars and in 19 of 20 cases you go bankrupt. Seems like a extremely +EV deal.

Not only not the end of the world, it’s a much more sound financial move :-).

This is a one-dimensional way of looking at things. I have a high credit score, never had a late payment in my life, but couldn't get a mortgage for any amount because I'm working for a temp agency.

Do you not have 2 years of W2 or 1099 income? With either, an FHA loan should be no problem, or even a Fannie or Freddie backed loan with mortgage insurance baked into the interest rate.

Income and assets are king when underwriting a mortgage, credit less so (depending on investor desires of the mortgage backed securities).

https://www.hud.gov/sites/documents/4155-1_4_SECD.PDF (FHA Guidelines: Borrower Employment and Employment Related Income)

Well, let's put it this way - I have less than 2 years of lack of W-2 income. But yeah, you are reiterating my point, that credit score isn't necessarily what everything is based on. And what I was also thinking, is that I would not charge into bankruptcy assuming I knew what the consequences are. Everybody says you can get credit right afterwards, but I think "yeah, and that means they think you're a good risk for some reason other than your personal habits of paying debts, which sounds ominous".

Meaning what? They're gonna break your shins?

I think this is called being judgment proof. I think robinhood gains nothing other than forcing bankruptcy upon them?

Robinhood will likely not, considering they are grossly non-compliant with Regulation T (and have been reported to the SEC and FINRA regarding this issue), which governs margin requirements. This is someone's risk management system failing on a trivial use case.

I agree that they are unlikely to go after them, but I think if you read the fine print of the margin product, the customer agrees that the borrowed money is a debt and must be repaid. Also RH could argue that the customer acted in bad faith, being fully cognizant that what they were doing was against the rules.

Robinhood extended margin it was not legally permitted to extend (Reg T is federal statute, btw). I am very interested in sitting in any court room as an observer where their counsel attempts to collect.

But they didn’t intend to, right? If I steal money from a broker’s desk drawer and use it to do dumb futures trades, surelt that’s not a regulatory violation on the broker’s part.

Great case to make that you are so incompetent as a broker-dealer that someone was able to extend themselves 250x leverage on the margin you extended. That's how you lose your broker-dealer license, which means your business dies if you're Robinhood (unless they're only going to offer a cash management account, which I guess might be a thing? even Credit Karma and Personal Capital are offering one now). As a broker, risk management is your job.

I guess that makes sense.

This, laws will overrule fine print or service agreement at any single time.

> it would be very bad PR for people to start thinking that they can lose a lot more than they put into their accounts

I don't know if it would be bad PR... The guy very deliberately leveraged himself because he thought he'd gain social approval from his peers at r/wallstreetbets

It's a great public service announcement for: just put your money into index funds and stop trying to gamble on stock earnings.

But that is the exact opposite message that Robinhood wants to send (even if it is the correct message).

I think Robinhood wants to send the message that they offer a simple, elegant stock trading app. I feel (no proof) that they target people with net worths of less than $50k to come and trade a few stocks. AAPL, TSLA, NFLX, MSFT, GOOG, etc.

I don't think they actually want you to trade on margin. It's just, some people are addicted to volatility / the chance of "sweet gainz" and they see "regular Joe" posting pictures of turning $1k into $100k by making "the correct lucky" options trade, so they are down to try to do it too.

I don't think that's Robinhood's message. It's just a side effect of having an easy to use app with no fees.

RH can simply not offer margin if they don't want their customers to use margin. "not handing out money" is the traditional way that anyone avoids the risk of losing money due to handouts.

> I don't think they actually want you to trade on margin.

Have you used RH? I use it for exactly your example, every other paycheck I put some in VOO and a bit on some individual stocks. They push Robinhood Gold so hard. There used to be a glowing gold banner at the top of your portfolio advertising to join gold and get $10,000 today or whatever.

Why don't you just buy VOO on vanguard considering there is no commission fee on vanguard when buy vanguard ETFs?

Because I'd still like to buy other stocks. There's also no fee on RH so what is the downside of using RH?

I disagree. I signed up to check it out and they’ll consistently push notifications about upcoming earnings calls. They’re clearly trying to promote a very short horizon mindset

While we are on the topic of leverage and index funds, can someone explain leveraged index funds to me?

If I believe index funds are going to have a positive return, why not try to lever it up as high as possible? For example TQQQ (triple leverage) looks pretty enticing compared to QQQ.

Leveraged index funds generally work as expected on an intraday basis - but they're not intended for longer term holds. You can of course try it, but things will not turn out as you'd hope. Here's an article describing what happens:

https://www.investopedia.com/articles/financial-advisors/082...

Outside of tracking error and expense fees, there is a more fundamental issue. When the market goes down X%, you need it to go back up Y = 1/(1-x)-1 to break even. So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more. So the average daily noise of the market kills you.

> So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more.

Can you explain why that is? I would have expected that your gain or loss from the leverage funds relates only to the difference in price between when you purchased and when you sold (multiplied by the leverage).

The leveraged funds like TQQQ reset their leverage on a daily basis.

the leverage amounts typically "reset" daily (not always; read the prospectus) so if you lose 10% (say $100 => $80) at 2x your day 2 base is $80; a 10% gain that day would average out to 0 on net but you would gain 20% of $80 => $96

Because of the triple leverage, a 33.33% drop would entirely wipe out the fund. Back to $0. A 33% drop in a single day has never happened (1987 Black Monday was 22%) but it definitely does happen if you consider a longer time frame.

Hence why it's reset daily, as the other two responses explain.

And in case it's not been made clear enough: it's the very opposite of a sound investment. It's very much a risk management / trading instrument. It's something you would trade as a hedge or leg of a complex trade; not something you want to hold by itself.

I read that 3x leverage is bad because of volatility drag or something like that so 2x "is the sweet spot"

SSO is 2x leveraged SP500

https://finance.yahoo.com/quote/SSO

Check out the chart since 2007 versus the SP500 index to today. I'm seeing 211% return for SSO, 113% for SPY.

Just remember that we've pretty much been in a full on bear market ever since the last recession. Whether or not terrible things would have happened to SSO if we experienced a true recession/crash and whether or not you would actually recover/beat SPY, I have no clue and am not qualified to say.

But, based on the cherry picked '07-'19, yes, SSO (2x SPY) beats SPY (1x SP500) 211% to 113%

It really depends, see my blog post on the matter (part 1):

https://smabie.github.io/posts/2019/10/04/vol.html

In short, assuming a normal distribution, your max leverage ratio should be the future expected returns divided by the expected variance.

I’m not at a computer right now so I can’t run the math on real S&P returns, but assuming 10% returns and 10% vol and a normal distribution, the highest leverage ratio you would ever be able to justify is 10/10^2 or 10x leverage.

In my blog post I looked at the beginning of 2018 up to present. The ideal leverage ratio according to my equation (I’m sure it’s not novel, but haven’t been able to find anyone else talking about it), is 2.99x.

Of course, the more skew or kurtosis the distribution has the less accurate this equation becomes.

Right now I’m working on a hypothetical S&P ETF that adjusts leverage bases on forecasted volatility and returns. Almost impossible to get right, but my preliminary model has outperformed (not risk adjusted) any fixed leverage I’ve thrown at it.

You made a blog post that 10x leverage would be good given the past 12 months (where the market has mainly been up-up-up)? Doesn't that 100% ignore the effects of drag when the market goes down-down-down?

First of all, the market has not been exactly “up-up-up.” There has been massive volatility and drawdowns in the last year.

Second, my analysis was from the beginning of 2018 to present. Using that data, the ideal leverage ratio is 2.99x.

Third, the ret/var model put forth in the post assumes a log-normal distribution. The less log-normal the returns are, the less accurate it becomes. Excess kurtosis or skew will definitely affect the accuracy of the model. So the model would probably be fine if the market was up-up-up or down-down-down, I haven’t encountered any periods in which the non-normality of the distribution is so severe that it completely breaks the model.

You also need to pay interest on the leveraged margin, so on the long term you'll lose more money on interest than you'll gain.

Clearly not, gains of the stock market are much higher than interest

This isn’t true. Market returns are almost always going to be higher than the borrowing cost. In fact, I can’t think of a single hedge fund that doesn’t use leverage either through: shorting, borrowing, options, or futures.

Leverage is almost always the secret sauce to institutional strategies. And if we’re talking about quant funds, without leverage they wouldn’t exist.

"Market returns are almost always going to be higher than the borrowing cost"

This sounds like perpetual motion to me. It's like Moore's law - no matter how long it's gone on for, it can't go on forever.

If everybody believes that, and people who actually control trillions of dollars do it on a massive enough scale, just borrow money and invest in stock, then it has to break things down at some point, doesn't it?

for a large number of reasons it's hella hard to make money in finance. you can make whatever the vanguard index fund makes "for free" in your pajamas, so in order to justify your existence as an org within a financial institution you're going to need to put together some returns that are, obviously, way higher than that. so out come things like leverage and derivatives (=> hyper-leverage).

and yeah, there are failures, and they lose their shirts, and the beat goes on. but you're probably not going to make very much money (=> last very long) if your rate of return is the same order of magnitude as the collateral you're taking out. it's just not worth it from the POV of the bank.

But isn't much of their money being made from fees?

Due to volatility tax [1], there’s an upper limit on how much leverage you can assume. This amount is a function of forecasted returns and variance: r/var(r). The larger this ratio is, the more leverage you can take on. In general, just investing in the broad equity market with anything above 3-5x leverage over the long-term is probably unadvisable. So groups like hedge funds first reduce their volatility by going long and short, and then leveraging up afterwards. Even with market neutral funds (0 market exposure), the leverage applied rarely goes past 6x nowadays.

Banks are a little different and while the rules are complicated, big banks need to have around 3% of their total book at hand. Or in otherwords, they have around 33x leverage. Because of the leverage, banks need a very diversified uncorrelated portfolio in order to reduce volatility. No bank would stuff all of their money into equities, the risk of ruin is too high.

Also, there’s another perspective to look at your question: the efficient market hypothesis. In short, EMH states that in general, all investments have the same or trend toward the same risk/reward profile. That is, the ratio or slope of the returns vs volatility should be the same. With debt/credit, there are two primary options: you get paid back with interest or you don’t (let’s ignore bankruptcy). With equities you are assuming a lot more risk, the stock could go up or down or whatever. Since you are assuming more risk with equities than credit, it would violate EMH if you weren’t compensated for the extra risk.

This however, doesn’t explain why equities perform so much better than everything else. This is called the equity premium puzzle [2].

So maybe you’re right? No one really knows. Maybe the jig will eventually be up? Or maybe not, no one really knows.

[1] https://en.m.wikipedia.org/wiki/Volatility_tax

[2] https://en.m.wikipedia.org/wiki/Equity_premium_puzzle

I spent some time thinking about leverage and margin, and my thinking was

- I don't want to invest on margin unless the interest rate is significantly lower than stocks generally return

- as a rule of thumb, 7% is a conservative estimate for stocks in the long run, while a typical broker charges close to 10%. So it seemed like a non starter.

- however, it is possible to find rates as low as 3-4%, so then the question becomes how much leverage to use?

- my logic was, what kind of drawdown is plausible if you invest at a market peak? It appears based on known history that -70% could happen. Therefore it would be best to limit leverage so that more than a 70% decline would be needed to cause a margin call.

- which seems to lead to borrowing no more than 25-27% of one's equity.

Just in case someone doesn't know about r/wsb and thinks it's just a degenerate gambling community.. they're sort of right but there's more to it. It is a community centered around self deprecating humor, basically people enjoy trying to become successful at trading, but they know the reality is that they're not very likely to succeed, so they share their trials and tribulations on r/wsb to make jokes about their own stupidity.

Some people are richer, either because they have good jobs, inherited or had prior success, so they lose more and the community enjoys their posts more.

The idea that you would do something stupid that costs you more money than you could afford (and possibly gets you into more trouble) just so that a group of people can laugh at you and make jokes at your expense is ridiculous, but I get that some people really crave that sort of attention. It goes a bit far to say that they get "social approval" from the community though.

I believe Robinhood is violating Finra rules around margin trading though. Do they really want to go to court and claim incompetence on their own part?

Trust is everything in fintech. Now that this story has moved from one obscure subreddit to Bloomberg I don't know how they start to reclaim it if they cannot calculate numbers correctly as a brokerage.

The consensus on /r/wallstreetbets is that Robinhood is a joke, which is pretty much the last thing you want to be thought of as a financial services provider.

Indeed, they should be worried about their own skin. The SEC should shut down their operations immediately, at least anything that involves margin. Like today. It's not even about PR, this is a pretty bad violation of federal law. We don't know how many people may be using it.

This is the financial equivalent of forgetting to check password on a login form. It's that stupid.

If they shutdown their operations today, that would be incredibly detrimental to existing users. what if I held an option expiring this week? Am I forced to let it expire because the SEC forced them to shutdown? Seems like a douchebag move. sensible thing would be to remove margin from all accounts. if you want to prevent anymore transactions, at least give people some heads up so they can liquidate time-sensitive positions.

> I believe Robinhood is violating Finra rules around margin trading though.

Yeah, this is why the scenario is unique to most other r/wallstreetbets losses. With a good attorney the guy may come out of this relatively unscathed.

How long ago was the whole /u/ir0nyman debacle with box spreads? RH's incompetence in the regulatory space has been pretty well known for quite a while now (well before ir0nyman).

Probably less than a year ago.

Yeah, but when this stuff becomes mainstream fodder it becomes more embarrassing to regulatory agencies if it is left unresolved in the public eye. The box spread thing wasn't on the frontpage of Bloomberg/CNBC AFAIK.

I don't know about the front page, but /u/ir0nyman definitely got a mention in Money Stuff, which basically constitutes "winning" r/wsb AFAICT. I doubt there's anyone in finance who hasn't at least heard of the ongoing wsb/RH drama at this point.

The consensus on /r/wallstreetbets is also that /r/wallstreetbets is a joke, so it's confusing.

Help me understand what is interesting about this bug that makes unauthorized margin trading RH's responsibility rather than the customer's? I thought I understood what was happening from the WSB thread, but since so many people here seem to think this is sui generis and clearly bad for RH, there must be something I'm missing.

To me, it looks like a bunch of people on Reddit found a bug and then, extremely ill-advisedly, exploited it flagrantly in real-money accounts they controlled. Based on my understanding of the situation, which may be weak, I'd be a lot more worried to be one of these customers than I would to be RH at this point.

They're both responsible, the difference is Robinhood has to settle the trade in a day, and then they have to try to collect from someone who likely doesn't have any assets to give them. And if they do, they will still likely have to take them to court. So it costs Robinhood time and money even if they get their money back, which is doubtful.

We don't have all the details.

Either they have a working portfolio valuation model, and they missed this rather obvious case of linking a written call to its underlying, or they don't have a proper valuation model at all. If they actually do portfolio valuation by simply valuing each line and adding them, then it's not just wrong but gross incompetence. It would not be the first broker to blow up due to mispricing clients derivatives portfolios. The idea that a startup is letting millenials trade derivatives like this is absurd in the first place.

It doesn't seem, from the descriptions, to be possible to exploit this bug without knowing that you're doing it. It's not like they simply don't enforce margin limits; in fact, it looks like you have to apply the bug iteratively to do anything interesting with it. That being the case, it doesn't appear to me like the people exploiting it will have any way of talking their way out of the intentionality of their actions, at least not to a "reasonable person" standard that would be applied in civil court. It looks like cut-and-dried fraud. Am I wrong about that?

Oh, in that case it's definitely fraud because, as you pointed out, it's clearly intentional (you have to repeat the trick many times).

But the $8 billion question is: are we talking about an obscure bug, a missed case in an otherwise perfectly sound valuation and risk management model, or is it actually a case of dodgy valuation and risk modelling? Which implies that many well-meaning clients are also seeing the wrong portfolio value, and trading with invalid margins?

Again, I don't have the details so I don't want to speculate too much, but apparently they've had similar "bugs", so it's possible that their entire valuation and risk model is dodgy. It has happened to more reputable organizations.

Bugs in the software come from bugs in the process. They are showing their process in their inaction.

If their stuff was generally sound except for this, they would have shut down margin trading until the bug is fixed.

It's hard to think of a bug or vulnerability that you couldn't compose an argument like this for. Does it matter? They left the back door unlocked; you'd still get in trouble for letting yourself inside.

They clearly don't take the issue very seriously, as they allow margin trading to continue. That is not normal. They're exposing customers to more risk than they should be, and that's a very serious no-no.

I don't think small bugs in high quality shops would fall under this argument.

What's a "small bug"? What's a "high quality shop"? I've spent years doing software security assessments for much larger financial service firms than Robin Hood, and found far worse things than this.

The broker/dealer I work for stops trading on bugs causing much smaller (even $0) material impact.

For brokers in particular, they are highly regulated and I can't imagine them not ending up with a nasty investigation+large fine from regulators over this.

Why shouldn't "millennials" be allowed to trade derivatives just like anyone else?

Good point. Generally, most people should not be trading derivatives.

I was pointing out millenials in particular because it's the population targeted by those startups, whose business models is more or less implicitly: millenials have no clue about money and finance. Which is true, but also unethical.

> millenials have no clue about money and finance. Which is true

Older millennials are approaching 40. The majority of hacker news members are probably millennials

The scheme is executed in two parts:

First, the user exploits the bug to build up a massive pool of margin. Roughly, this is equivalent to taking out a $50,000 loan from Robinhood

Second, the user buys $50,000 of soon to expire options. Roughly, this is equivalent to pairing with another (innocent) trader, each putting up $50,000, and flipping a coin for the pot.

If the user wins the coin toss, then Robinhood is fine: the user pays back the $50,000 he borrowed, keeps the $50,000 he won, and Robinhood nets some small amount of interest for their loan. However, if the user loses, Robinhood never gets back their $50,000 dollars. That money is now in the possession of the random trader who was on the other side of the coin toss, and there's no way to get it back because that trader legally won it. The user who ran the scam owes Robinhood $50,000 but that debt is close to worthless.

It doesn't really matter who is responsible. Even if Robinhood prosecutes everyone who perpetuates this scheme and sends them to jail, they'll still never see their money again.

"Roughly, this is equivalent to pairing with another (innocent) trader, each putting up $50,000, and flipping a coin for the pot."

Seems like a better game if the other party is not so innocent, or independent...

If the other party is not so innocent, I believe that counts as market manipulation, which is highly illegal.

There's not much incentive here to do that, anyway; it doesn't increase your expected value over the original coin flip.

RH probably won't be repaid, but they have incentives to recover here. Every state is different, but e.g., in California the median wage is about $20 / hour, and you can garnish 25% of the income above the state minimum wage of $12 / hour. That's about $4,000 / year. It's probably not worth it for RH to sue for this, but they might get back $10–15 k from a debt collection agency, which are designed to recoup debts over a period of years, all the while collecting hefty interest payments.

Are we talking 18-19 yr old teenagers? Because anything less and they shouldn't be able to have an account on their own. And of they do, then Robinhood would be sol. You can't enforce a contract on a minor. (although, interestingly, a minor can enforce a contract on an adult)

Is 18-19 considered a minor in the US?

No. Age < 18 is considered a minor. Everyone on r/wsb calls each other autists and uses old 4chan slang like teenagers. I think some of the guys who caused Robinhood to change their system were minors.

I visit /r/wsb pretty frequently, so I would like to add two bits of information that might change your mind.

1) The user /u/ControlTheNarrative (CTN) made plenty of posts before losing the money where he made it very clear he knew exactly what he was doing. He had a post where he spelled out exactly how to gain the extra leverage and that his "personal risk tolerance" meant he could handle 25:1 leverage. Additionally, his response after the fact was something along the lines of "once I earn another $2000, I plan on doing this again". This kid didn't just click a wrong button and end up with the extra leverage, he was well aware of what he was doing.

2) Take this one with a major grain of salt, but based CTN's comments in the original posts and some comments by other users, it seems like this might not have been the first time CTN has used this exact trick to blow up an account. When the video was first posted, multiple commenters mentioned that he'd done it before and some of CTN's comments after the fact seem to hint at that. Again, take this with a huge grain of salt since I have nothing concrete to back that up.

The last time RH was in the news for some user losing way more money than they had (IR0NYMAN) I actually felt for the user a little bit and can understand why RH (supposedly) didn't go after the money after the fact. IR0NYMAN was creating box spreads, which can be a legitimate strategy, although they are very hard to find a situation where you can make money with them. That user stupidly didn't understand RH's rules around options exercise which is how he got screwed, but had he been able to hold all his contracts to exp (like European options allow) he actually would have been fine.

I can understand RH writing off IR0NYMAN's debt because it didn't seem like the user truly understood what he was doing, but this one feels different, IMO.

Very important context. Thank you.

If you try to sign up for options (or margin) trading on any brokerage, none of them will let you do it unless you affirmatively confirm that you understand that: not only can you lose your ass trading derivatives, but you can lose asses that you don’t currently have and you can lose asses that you didn't even know exist.

Doesn’t RobinHood have these disclosures and gates?

Yes they do. In my uneducated opinion, legally, it seems both are responsible for the money.

Whether RH goes after them is a totally different story though. You can't squeeze blood from a rock.

You basically fill out a form and check a couple of boxes. It's about a simple as opening a Facebook account. This is not much of a deterrent.

There is no requirement that you understand anything except how to check that checkbox that says, “yeah, yeah, I promise I read the PDF you sent. Let me trade da options!!!”

Some brokers have different levels of option trading privileges, and require you to attest to a certain amount of experience to get to the highest.

I'm not sure if there are any consequences to lying about your experience, but in principle, you are claiming certain facts in writing, not just saying you read a disclaimer or educational material.

I find the idea of a serious legal professional having to read through those threads on WSB actually makes me happy.

r/WSB seems to be a Wall Street 4chan and it's definitely pretty funny reading through some of the threads.

4chan is a degenerate pile of nazi dung, most of the time. WSB is mostly innocent fun.

4chan is more than just /pol.

/pol has leaked all over though

Spoken like someone who hasn't visited since 2015.

/pol/ and /b/ are only two boards out of about 80

That subreddit cracks me up more than the rest of Reddit combined.

Guhranteed

Let's say the user is able to profit with the options, quickly requests a transfer to their bank account and it completes. Can't Robinhood withdraw the money back from the users bank account claiming fraud?

technically it’s ir0nyman1 but who’s counting

on a more serious node: RH should close the loops and be thankful that someone is finding these bugs for free - well almost

I'd expect the gamblers will simply be bailed out. That is the precedent from 2008, is it not?

> it would be very bad PR for people to start thinking that they can lose a lot more than they put into their accounts

LOL WAT? If you are using the margin feature of your brokerage account it should be implicit that you understand you will lose more money than you have. Many people have bankrupted even due to a temporary fluctuation in pricing causing margin calls. This is true even if you don't trade options, just less likely so.

Personally I trade options but I don't enable the margin feature on my account. Then the worst case scenario is I lose everything I put into the account; I wouldn't lose the money I didn't put in my account.

It’s not implicit, it’s explicit in the margin agreement you sign to create or extend the account.

You’re also on the hook for any excess losses that are not covered by cash in the account. They can and will go after the rest of your external assets.

> will

Can. It is isn't a certainty for those that understand, but if you don't understand that will is probably correct.

Well, it's not normal to lose more money than you have, even if you are investing on margin, because obviously that creates risk for the people you owe that they don't want. That's why there are minimum equity requirements and your positions can be liquidated without even a margin call if necessary.

A million YouTube views is worth a couple grand right?

Maybe there's an upside for this guy after all. 2019 is weird.

Much depends on the ad network. The default YouTube one, which is essentially the only network you can easily get into with a single video, paid me 23 cents CPM for video-game genre.

You need 1k subs to monetize

FDs all day!

>It will be interesting to see if Robinhood will go after (i.e., pursue claims in court) teenagers who get carried away and rack up $50k+ deficits from this.

The PR would be a disaster.

I really liked this ELI5 explanation how does it work

https://www.reddit.com/r/wallstreetbets/comments/dqg6xx/infi...

The original guy (CTN) stopped at 50k and posted the famous video where he basically lost everything but that's another story lol https://www.youtube.com/watch?v=A-tNkuYV4_Q

People were speculating that what would be the uppermost limit before Robinhood does anything and turns out you can even get $1m...

Bear in mind that an ELI5 constitutes an advanced level of understanding on r/wallstreetbets.

r/wallstreetbets is consistently one of the highest quality subreddits when it comes to pants-shittingly stupid decisions paying off for the group (in terms of comedy, not actual money or wise investments).

For strict entertainment value, I rank it higher than any other site on the net.

They're really everything great and terrible about the internet and investing. I love it.

I think part of what makes it so hilarious is the real-life effects. Other communities might have inside jokes but on WSB they're references to times people committed financially insane actions with real consequences. There's not only hilarity, but a morbid curiosity that makes me laugh and gasp at the same time.

But there are also the situations where some concave skulled moron manages to be so stupid, it actually costs a company like Robinhood and WSB comes out on top (see - 1R0NYMAN)

Well that would just be another one of the real-life consequences, good or bad, for either party involved.

I think 1RONYMAN is smarter than a lot of the people that laugh at him. Terrible judgement. But intelligent.

What the hell was this guys APPL position, and why did he not know what would happen long before market open?

Word on Reddit he had done this before and understood what was happening just fine but did this to make a point. There are specific processes to get the leverage that high and he was allegedly able to handle it. See a comment higher up in this thread.

He bought 50k of Out of The Money PUTs expiring next day. So he bet AAPL would go down. When market opened AAPL went up and his 50k options would expire worthless at the end of day.

To get the leveraged money he bought stock and sold CALLs against it. RH has a bug where they give you credit for the premium collected instead of reducing buying power.

Also he picked his position because he thought apple was overvalued due to having too many female execs. Even if we concede his point, that should be priced into the stock already, no?

It may be priced in the stock if other traders have the same logic.

If you think it's a good investment thesis, a better strategy would be to build a portfolio where you go long on a basket of stocks with "not too many female execs" and another, offsetting, short basket of stocks with "too many female execs". If you do that properly, you should be able to almost entirely eliminate market and industry risk and basically "amplify" your investment thesis.

This is what a hedge fund originally was (now usually referred to as long short equity funds). Relative value trading. A lost art in our current central bank driven markets.

"Next he goes to the local stables. After watching horses mount each other for a while, he buys a thoroughbred foal for $20k. At Bible study that night he meets someone willing to pay him $19k for breeding rights to the horse as an adult."

I actually find that explanation not very helpful and only broadly right (in the sense that he used premiums from writing call options to lever up even more). Almost everything else is wrong, tbh.

Some important aspects:

* CTN isn't holding cash, he's holding $F stock and offsetting ITM call options. * The leverage he's getting isn't on a linear payoff. That is, it's not like I get a $1M loan on a $4k collateral. His position is more conplex and his payoff profile is nonlinear. I describe that more here: https://news.ycombinator.com/item?id=21457524

It's funny, and it's most likely wrong for RH to allow him to put on that position (in the unlikely event $F craters, RH is on the hook for _a lot_ of money).

But it's not as simple as explained in that reddit post.

The person that got $1M has very limited upside though because they sold deep in the money call options on the same stock that they own, Ford ($F). This is known as a covered call e.g. as the price moves up your stock is worth more but the premiums on the call options you sold increase as well, limiting your profit.

On the other hand, if the stock tanks you will still lose, though the premiums from your options you wrote will cushion your downside.

The Youtube guy owned naked puts, which is far riskier than covered calls.

Selling deep ITM options is one step in the "hack" to create infinite leverage / infinite buying power.

Buying weekly OTM options is the "yolo" they do once they mess up Robinhood's margin into giving them hundreds of thousands of USD of buying power.

Right, but looking at the $1M guy's positions he doesn't own naked calls/puts it's mostly a covered call on $F.

That's actually super smart.

If you ever get such ridiculous margin you should buy things that have high chances of very small profit, such as selling deep OTM options or credit spreads. Wait for expiration, unfold the scheme, collect your profits, disappear.

If you leverage up to $1M a small 2% profit with 95% chances of success is an easy thing to achieve by selling options, and would pay you $20k instantly. In the 5% outcome your margin will just totally blow up, like LTCM in 2000, or the whole idiotic concept of Value-at-Risk in 2008.

Yeah curious what Robinhood does here e.g. if they close his positions right now he's probably made 5 figures or so given the upward move in $F. Do they let him keep it or what?

They may be on a hot meeting with the SEC right now.

He doesn't benefit at all from $F going up because he's written call options on his entire stock position.

This is bad advice. Assuming your plan is not to pay back if your $1m goes bad, your edge comes from that scenario, so you actually want to maximise the chances of it. Much better to "put it all on black" and take a 50% chance of making a 90% profit - also easy to achieve by buying options. For best results, have a friend do the same thing but put it all on red, and agree to split the money.

On the other hand, if you aren't planning on running away from your losses, you shouldn't take the 5% risk of a 100% loss to make just $20k. Liquidate the options and put your money back in index funds.

A 2% profit with a 5% chance of going busto doesn’t sound like a super smart trade, unless I’m missing something.

95% probability of winning 2% of $1mn = $20k

5% probability of losing $4k

Not so bad (if you can get away with it).

The expected value of such a trade is 19.2k. That sounds pretty fucking good to me. Of course, there’s some externalities not accounted for in that math.

That’s if you expect to be on the hook for downside risk. If you’re a teenager willing to go bankrupt (and face criminal charges) if the bet goes south then you should maximize your risk.

Yeah, I think the $1M position in $F is capturing people's attention, but that's not the entire story.

For every share of $F he has, he also has an offsetting deep ITM call option he's written. He doesn't have $1M risk on - or rather, he doesn't have linear risk on.

The payoff for a covered call looks like this (sorry for the paint): https://imgur.com/a/J6vcUty

P is the price where he bought the Ford share. S is the strike price. S << P since he's writting deep ITM calls. The combined payoff is just the sum of the stock payoff and the call payoff.

As you can see, he's fine, as long as F doesn't tank. If it does, he's on the hook for some money. So he didn't lever up a linear payoff in the stock price, he levered up the payoff I showed above.

Really, everything is fine, as long as Ford share price stays above the strikes he wrote. If it goes under, CTN goes bankrupt and RH can't get their money back.

But this is a lot more subtle than getting 2:1 or whatever linear leverage.

Also, I'm salty because I submitted the same story before this was posted, but it died in the "new" queue.

Did you read about the bug? The point of these trades was to trigger the bug. Not to make money on them. Selling options triggered the bug and gave you more margin than you should have had

From the article:

>The problem arises when Robinhood incorrectly adds the value of those calls to the user’s own capital.

This is not precise. Premiums received from short options positions _do_ get added to your "capital" and show up as cash in your account. You will accrue interest, etc. on this cash like any other cash in your account. The premiums should _not_ increase your margin/buying power which is where RH made a mistake.

Not quite. The issue is that Robinhood incorrectly valued the stock collateral covering a short call position. It should be valued at the strike price of the call option, rather than the current spot price of the security.

Eg, suppose FOO is trading at $100/share, and you have $5k of cash and $5k of free margin. You use all $10k to buy 100 shares, then sell a call option with a strike of $60 for $40/share.

Under RH's calculations, you have $5k of account equity, $10k of stock and $4000 of cash from selling the call. This qualifies you for a margin loan of up to $9k.

Under the correct calculation, the stock is only worth at maximum the $60/share strike price of the short option, since that is the cash you'd get if the option is exercised. So you have $5k of account equity, $4k of cash, and $6k worth of net marginable securities.

The advantage of this is that it treats out-of-the-money covered calls better. If you sold a call option on FOO with a strike of $105 for $2/share, you should have $200 extra free to spend on stuff. Selling extrinsic value should wind up generating net cash that users can use for whatever purpose they want. Selling intrinsic value, on the other hand, is selling a portion of the economic right to the underlying.

This seems like the sort of thing that happens when the people writing the code don't know the domain, and the domain experts can't express how the software needs to be tested.

This entire class of bugs should be caught via fuzz testing. Swap out the live back-end with one that fakes execution against a snapshot of prices, do whatever you can do, and verify position sizes are within leverage limits.

That probably would help. I think a properly functioning margin system would never result in negative balances on liquidation, as long as the fake executions were filled at exactly the trigger price. Doing crazy but valid shit and looking for negative balances would probably catch other issues too.

This is easily the best explanation of RH's goof in this entire thread.

“...I repeat this until I am sufficiently leveraged for my Personal Risk Tolerance. Right now I am at 25x leverage because I had 2000 dollars in Instant Deposits.”

Of course it’s within his risk tolerance. He has the potential to turn $50K into a lot more money and would only lose $2k if it goes south (and it did.)

It’s going to be a sad day if Robinhood goes under because a bunch of gamblers lost Robinhood a couple million dollars. It’d also be sad for them if in later developments they find out their Margin Call feature didn’t work as advertised.

Well. Robinhood then should better debug their platform unless these bugs actually make Robinhood more money when people overleverage, lose and don't advertise it online.

it's their own damn fault. Turns out "Move fast and break things" doesn't necessarily apply to all industries.

If you lose 50k it is your problem, if you lose 50m it is the Robinhood’s problem now.

If someone loses 50m, it could become a problem for everyone with a margin account or everyone with a cash account and uninvested cash in their Robinhood account due to Rehypothecation Risks.

But first it would be a problem for the owners of Robinhood private stock as their shares are severely diluted for huge equity infusions.

Won't be that sad. They should make sure they can't be so easily exploited by the hilarious and insane dummies in WSBs.

"Personal Risk Tolerance" has become a meme in WSB just like "literally can't go tits up" has become a meme.

"Personal Risk Tolerance" = said by /u/ControlTheNarrative before losing $50k in AAPL puts

"Literally can't go tits up" = said by /u/1ronyman before his position went literally tits up (because one side was American options while the other were European options). the dude did his DD up until that difference between American and European contracts.

Summary: Robinhood's margin system is completely broken and allows for practically infinite leverage. One guy leveraged up to 1'279'550 USD on a 4'000 USD deposit.

Current "leaderboard":

https://www.reddit.com/r/wallstreetbets/comments/drt5tr/guh_...

And an outbreak of memes on Reddit:

https://www.reddit.com/r/wallstreetbets/comments/dr4iem/cont...

https://www.reddit.com/r/wallstreetbets/comments/drxcpw/this...

https://www.reddit.com/r/wallstreetbets/comments/drsxau/the_...

https://www.reddit.com/r/wallstreetbets/comments/dr3eki/say_...

https://www.reddit.com/r/wallstreetbets/comments/dpwa5v/in_l...

People wondering what is Robinhood even doing, and that it's in violation of the federal law:

https://www.reddit.com/r/wallstreetbets/comments/drmr6y/how_...

https://www.reddit.com/r/wallstreetbets/comments/drn8gf/this...

https://www.reddit.com/r/wallstreetbets/comments/dr6gus/robi...

Haha thanks for this, I haven’t been laughing this hard in weeks!

The best meme was someone saying, it’s now only a matter of time before Masayoshi Son invests in Robin Hood!

Chris Sacca took advantage of a similar glitch in the early days of online brokerages. [1] The leverage yielded phenomenal returns before it sent him into $4M of personal debt. It took him years to climb back up to $0.

[1]: https://www.financemagnates.com/forex/brokers/chris-saccathe...

He was able to negotiate that $4M debt down to $2.125M, [A] proving once again that if you owe the bank $100 million, it's the bank's problem.

[A]: https://pando.com/2012/11/01/how-chris-sacca-turned-his-stud...

Of course /r/WallStreetBets did this.

Isn't this essentially how the entire world economy works? This is exactly what it means when you saw headlines like "$60 trillion of derivatives are poised to come crashing down" around the time of the 2008 financial crisis. It's futures on leverage on futures on leverage, with all different kinds of counterparties sucked into the tangle.

I know basically nothing about finance. But /r/wallstreetbets is endlessly entertaining.

> I know basically nothing about finance.

Neither does anyone on r/wsb, which is why it is entertaining.

Lot of it is a facade for entertainment value. A bunch of posters trade for a living. You’ll see screenshots of Bloomberg terminals.

For reference, Bloomberg terminal costs $24,000 per year.

Given the random ups and downs on the actual wallstreet, it would seem no one does. Makes sense as it's mostly gambling.

Before the 1928 crash and subsequent regulation as well as going off the gold standard, instituting the Fed, and other things, the ups and downs were insane in both socks and inflation.

Consider the DJIA here from 1919 to 1929: https://www.macrotrends.net/1319/dow-jones-100-year-historic...

See inflation here for 1920 to 1929: https://inflationdata.com/articles/inflation-consumer-price-...

See the massive fluctuations in inflation as well as the DJIA? After the New Deal and other reforms, we not only hit post WWII American growth but a relatively stable upward trend in the markets and policy with targets like stable economic growth and more recently stable inflation (currently I think a 2% target).

Regulation and restrictions plus Fed oversight has granted our modern economy relatively stable year over year growth and inflation. Stability means future predictions become ore accurate, economic panics/recessions can be not necessarily predicted but solutions approached strategically.

Deregulation and instability can make people insanely rich similar to the hyper leveraging of this whole RH thing but one usually has to either be the know like via have insider information or be prepared to tank everything for their own arrogance like when some guys tried to corner the gold market in 1869 (Black Friday) or the onion market in the 1950's: https://en.wikipedia.org/wiki/Cornering_the_market

This page where I pulled inlfation data is really neat. I'd recommend checking each decade with recessions: https://inflationdata.com/Inflation/Inflation_Rate/Historica...

This is legendary - leave it to WSB for gaming this. The fact that Robinhood even allows recursive margin is a total failure on their part.

I'm just waiting for Bloomberg to add haupt91 videos on the front page.

Makes smartphone investment product catering to unsophisticated and younger investors.

Makes options trading available to these customers.

Screws up risk management by incorrectly adding the value of those positions to customer's margin liquidity.

Incurs losses as a result.

::surprised pikachu::

"If you take advantage of someone’s mistake to line your own pockets, you need to pay them back." -- if that were the actual governing law I can only imagine that many brokerages catering primarily to unsophisticated investors (not to mention credit cards, and many other financial services) would be having a pretty bad time.

Has this been fixed yet? It seems like a company-ending disaster for Robinhood if the bug remains exploitable now that it's on Bloomberg.

If they actually have a proper portfolio pricing model (to compute the available margin), and they're just missing one use case, then that should be relatively simple to fix. A few days, or a few hours if they really put their heart into it.

If they're completely lacking an option pricing model... they're just not going to add one overnight. They'll have to add a standard model (most likely Black Scholes), come up with an estimation of volatility to feed into it (you can extract it from the market; implied volatility), and also solve the problem of linking derivatives to their underlying. In any case this is not a simple arithmetic accounting issue.

This seems to the be case given that so far all they have done is freeze accounts and blacklist attractive options of used for this play.

Chris Sacca (legendary VC) exploited a similar bug in his early days.

https://en.wikipedia.org/wiki/Chris_Sacca#Stocks_and_Fenwick...

> Sacca used his student loans to start a company during law school, and when the venture proved unsuccessful he used the remaining funds to start trading on the stock market. By leveraging trades for significant amounts (discovering a flaw in the software of online trading brokers in 1998)[18] he managed to turn $10–20 thousand dollars into $12 million by 2000.[19] Eventually, when the market crashed, Sacca found himself in debt with a four million dollar negative balance.[18] He negotiated to have it reduced to $2.125 million[17] and had repaid it by February 2005.[18]

Given Robinhood's lack of quality control, I'm not sure why anyone uses them anymore. ETrade has free trades now (thanks Robinhood!) and a much more robust platform and API, and a hell of a lot more assets backing them.

What is the advantage of Robinhood over ETrade at this point?

>What is the advantage of Robinhood over ETrade at this point?

This type of yolo nonsense and pure comedy value, from what I can gather.

There's no advantage at all. Any other brokerage is better than they are.

I think Robinhood's valuation is probably nosediving off a cliff right now.

There is no advantage. Their only edge was $0 commissions. They're definitely going out of business. Robinhood is going to be a legendary example of how first-mover advantage doesn't work.

Same reason people use Dropbox over a command line hack job for syncing files.

User experience. It's just that much better.

Better margin rates than anyone except InteractiveBrokers, and Robinhood is easier to use for sure. (having used both)

ETrade's margin rates are over twice what Robinhood's works out to.

If you have any amount of money or equity held by Robinhood, you should seriously consider moving it to another broker.

This has the potential to end the company financially (at least until another round of funding bails them out) or regulatory (if they lose their licence over this).

Let's say RobinHood went out of business tomorrow. What would happen to all the stocks held by their customers?

https://en.wikipedia.org/wiki/Securities_Investor_Protection...

https://www.barrons.com/articles/testing-the-limits-of-broke...

This should explain it.

https://www.investopedia.com/articles/investing/050515/what-...

OK, that's sensible. So I guess there's really no need to do anything dramatic if you're a Robinhood customer, if you don't have over $500K in cash/securities.

Robin Hood customers absolutely should consider switching. These are the basics, and they can't even get it right. Would you trust a GP who didn't know how to use a thermometer? What happens if it's the other way around, and the customer's account shows a net profit but their books don't reflect that?

It's a bug with a non-normal use case. Most people don't use margin, and they don't sell covered calls, let alone do both. I just buy and hold regular shares, so I don't forsee how they can mess that up in anyway. If they do, I definitely will move my account elsewhere. But for now, it's still a huge hassle to move everything to another brokerage.

Who? I have tried with a couple of other brokerages, but found the entire UX to be absolutely horrendous.

As much as RH is in the news for screwing up, I think that they have stumbled onto something that the more established brokerages either (a) just don't get, or (b) cannot replicate without the risk of losing existing customers.

I’m pretty happy with Schwab. I find Robinhood cartoonish in comparison. Schwab provides so much more information.

Schwab, Fidelity… Many of the more established brokerages just have slightly old-fashioned UX while being perfectly usable.

Just because RH is in legal/regulatory trouble does not mean your money is just going to disappear. It's a fiduciary, not an ICO. Financial firms must have disaster plans that involve giving or transferring all of your assets back to you if it all ends. Selling your positions because of this would be a misinformed decision.

point of clarification, you don't need to sell any positions to perform a ACATS transfer

> Selling your positions because of this would be a misinformed decision.

That is why I specified moving. That should not be parsed as "sell everything".

My concern would not be losing my money/positions. My concern is Robinhood losing its license and then being stuck on a comically long cue while they hire 5 under-motivated temps to handle hundred of thousands of account transfers. Their customer support is already terrible now. I can only imagine what that incompetence + financial collapse + end of operations would look like.

I am assuming the prospect of being locked out of your accounts for several weeks/months would be stressful, not to mention the monumental task that may be involved in getting certain records back in place for tax season.

I worked at a fiduciary that went down so feel confident speaking to this. You're still not getting it. It's not like other startups that fail where you just get some temps and hope it solves itself. You have a specific timetable from the moment you lose your license to transferring every cent out. Past that window, there are penalties and further legal problems with the SEC. It's safe to say anybody – even slimy companies – are in full overdrive as this is going down.

ACAT is not that simple. Most brokerages charge you a fee of upwards of $50 to do it. If the brokerage is going down and they must invoke an ACAT for you, they eat the fee. Again, it's misinformed to be incurring charges and even potentially taxable events because of your philosophical beliefs in the success or failure of a company.

Layperson here, but isn't that called a run, and aren't those legally mandated disaster plans there to prevent runs?

I'm amazed anyone is sticking on that platform now that td / etrade / schwab went to free trades. There's no reason left, other than you want dumbed down tools / don't know better.

Maybe its just me, but these "dumbed down tools" are working fine over here. What fantastical brokerage experience are you guys expecting here that Robinhood doesn't support?

Are some of you actually concerned that your money is going to disappear overnight because it's in RH? I can assure you this is not a thing, unless you legitimately made very poor investment decisions with said money. Also, if this is the case, any of the above platforms will provide a virtually identical journey into poverty.

1. No dividend reinvestment tools so you’ll have cash drag unless you hand hold it

2. Inferior research tools

3. Fewer investment options (just stocks / etfs, no bonds or mutual funds)

4. Lacking support (ideally you don’t need this but having fantastic support can be nice over the long haul and most established firms have excellent support)

5. It’s only brokerage whereas pretty much anywhere else is going to allow you to consolidate retirement accounts

6. Tax reporting is a lot better in established firms but I might be dated here, looks like they built out some syncing tools in last year or so

I’m sure robinhood is fine & I wouldn’t be worried about losing money, and if it works for you great. But you can get a lot more from a bigger brokerage and I don’t know what they’re going to be able to do to differentiate now that free trades are mainstream.

Someone on reddit posted this, which makes it seem like Robinhood support is actually ok with the strategy: https://m.imgur.com/a/g4tpH9y

Of course I can’t verify the authenticity, but it doesn’t look good for them. In particular it seems almost financially smart to make incredibly risky plays on huge amounts of margin if you actually have very little in terms of assets, because the downside is you declare bankruptcy (doesn’t matter, you had no money) and the upside is hundreds of thousands of dollars

They aren't OK with it - it's a legitimate bug because it violates FINRA rules around margin trading that they have to comply with.

I agree that it violates my layman understanding of FINRA, I’m just saying that RH support doesn’t seem to be aware of that

Well it's not their frontline's fault but RH's executive team that is ultimately responsible. They've been in business for 6-7 years now and just discovered this issue? It's unacceptable, IMO. Hard to take them seriously when things like this happen.

You ever use RH? It's been hard to take them seriously since day 1.

It's funny because this is how money is created in the American Economy -- through recursive loans like this from banks. Since most money is digital now, nearly every loan becomes another person's bank balance and every bank balance is subject to be lent out. With a federal reserve requirement of 10%, the theoretical max leverage ends up being 10x so $100,000 of bank-created money for every $10,000 entering the banking system. This assumes the system works as intended and a bankster hasn't yet found a Robinhood-like glitch in the financial system to create unlimited money.

these people should just trade futures - you can buy a treasury bond future at effectively ~70x leverage without trying to defraud your broker...

Real brokers like InteractiveBrokers make you fill in a survey where you detail your experience and trading history before enabling you to do highly levered futures trading (and lying to them about this dramatically weakens any legal protections you might otherwise enjoy as a customer). Also, they have much tighter risk controls and will liquidate an account automatically if it gets to a dangerous level. And they also require a significantly larger account size before they will enable margin-- an amount that most teenagers are unlikely to have in liquid assets.

all futures brokers have to do this to extent, and theyre all good things.

you can day trade futures (ignoring newer cme e micros) with a $500 deposit and its an awful idea for a plethora of reasons, but grown adults do it day in and day out blowing out over and over. its clear this leverage needs a little more oversight.

i will note however, i found myself over leveraged in an options position in august 2015 using TDA, and my account went very negative as the platform went completely down for the entire day and no automated or human risk liquidated it on their side..

What happened in your case? Did you have to pay back the loan or were you able to walk away from it?

this was futures options positions. when the platform came up the next day (mind you, no one was answering the phone the times i called, i bet others got killed), I had money in my account so i didn't get what i completely deserved.

I was trying to get some hedges in as soon as ES opened limit down again and i did manage to get a few off. ToS data was nearly instantly frozen so I was using another feed to gauge my orders. I digress with thinkorswim is not good for heavy intraday (and the market data is pretty bad anyway).

after this event, i changed brokerages and focused 100% on day trading and make a living, so it wasnt all bad i guess!

I can only image robinhood has no risk desk, or automated system that do not work correctly for non-trivial option legs

What did you switch to, IB?

nah, a smaller boutique ish futures broker. IB has excellent order execution and absolutely horrible market data, but i used to use IB with CQG data until they instituted a monthly fee to accounts with high risk positions in (i had a small amount of naked puts, but the fee easily became substantial). i do recommend them if you dont write naked puts etc and dont day trade or use other data

Not sure about IB, but the surveys at most brokers are jokes. You check a couple of boxes in a form, possibly over-stating your experience. The next day futures, options, or whatever you wanted is turned on.

It's not really about the leverage on its own. As Levine points out in his take on it [1], it's about finding ways to "hack the system". And, in no small part, entertain the merry band of fools at r/walllstreetbets

[1] - https://www.bloomberg.com/opinion/articles/2019-11-05/playin...

Sure you can get lots of leverage with things like treasuries and forex. That’s because the underlying securities are so boring and non-volatile it’s safer for the lender. In this case you can get as much leverage as you want, and can spend it on silly, extremely risky things (such as a far OTM option expiring in a few days) which is dumb from the perspective of the lender

The fact that the app doesn't prevent you from doing this doesn't make it ok to do. It's pretty likely that borrowing and trading on the basis of nonexistent collateral is securities fraud.

I'm not an expert eg I haven't even done series 7 but I did the comparable securities certification in the UK some time ago and exploiting this "glitch" to trade using leverage without real underlying collateral would almost certainly be considered fraud in the UK irrespective of whether the app allowed it. In the UK regulatory regime Robin Hood would likely also be liable for different reasons.

Dealbreaker (fwiw) seems to agree with me - its strapline for this story is "Press X, Y, Down, Down, Left, Y, X for what has to be securities fraud."

https://dealbreaker.com/2019/11/robinhood-has-a-securities-f...

As a RH user, the fact that this is possible really scares me that there will be intervention/repercussions and that Robinhood doesn't know what they're doing. Is it possible for the FTC (or whichever entity) to freeze these guys' operations? Should I liquidate and move all my shares elsewhere ASAP?

As someone posted elsewhere, you are fine: https://www.investopedia.com/articles/investing/050515/what-...

That said, the only thing RH really has going for it is their decent UI experience. Everything that else matters sucks: Customer support, terrible price fills, uptime, and apparently their ability to write software which protects the end user as we are finding out.

As an option trader on the side I moved to Tasty Works awhile back, the same team that made TD Ameritrade's Think or Swim software, and a company which runs a daily 8 hour show focused on learning for free. Shameless signup link with referral code: https://start.tastyworks.com/#/login?referralCode=2GSNAJGJSQ

https://outline.com/sCeKc7

Didn't know this service existed, how do they not get taken down for rehosting content without permission?

Someone has used this to turn $3000 into $1.7m now...