Market action raises questions; here are answers

February 11, 2021 by admin

The action surrounding GameStop stock, the Robinhood trading app and short-selling in general have raised questions in the minds of many investors. Here are a few of them that were sent my way.

From Paul in Seattle: Settle an argument between me and my son. He started investing using Robinhood. I have been invested for years with Charles Schwab. He says the GameStop trading halt on Robinhood could happen on any stock and with any brokerage firm; I say that it wouldn’t happen if he had gone with an established firm. Who’s right?

You both are, but in different ways and for different reasons.

First, Robinhood is an established brokerage firm. It may be new and relatively young – having launched in 2015 — but that’s no reason to dismiss it or any other new trading platform.

Trading halts can happen at any brokerage firm, regardless of size. While Robinhood and Interactive Brokers – and services like Cash App and Webull — made headlines for trading halts at apex of the GameStop, AMC Entertainment and other frenzied action, they were not alone.

The issue was how far firms had to go, whether they halted trading, put new rules/restrictions in place or did nothing different.

Charles Schwab was affected here. Schwab and TD Ameritrade – sister companies – didn’t halt buying or selling, but did restrict some options transactions and altered margin requirements on the stocks with the heaviest trading.

The biggest, oldest, best-capitalized brokerage firms are less likely to be affected in crazy trading times. If the newbies can’t create a cost advantage – which they can’t when trading is free – this is a clear benefit to siding with the name brands.

But every brokerage big and small has investors sign papers acknowledging the possibility of trading halts and more; no one pays attention to fine-print warnings until they become real at the worst possible time. No matter the firm you work with, it would be a mistake to assume that there’s no devil in those details.

From Mary in Richmond, Va.: My kids are considering penny stocks right now because of all the buzz (frenzy?) on Twitter. Call me conservative, but I’m worried. Should I be?

Their excitement is easy to understand. Penny stocks are a way for a small/new investor to start trading where they can buy thousands of shares for a little money. While most penny stocks do not see fast movement in their market price, the ones that do can make big price moves in a matter of days, rather than years.

The downsides: low-quality companies with train-wreck balance sheets, risky markets with less regulation, thin trading, heightened volatility, the potential for scams, lies and pump-and-dumps, and the tendency toward all-or-nothing results.

The reason why you should be worried, however, is that the vast majority of people who take a shot on penny stocks wind up losing money. Even the guys who are true believers in penny-stock investing acknowledge that the losers way outnumber the winners.

For would-be investors, penny stocks are less relevant than ever.

You can buy fractional shares – slices of stocks – in brand-name companies, which means you don’t need gobs of money to invest meaningfully.

It’s about the money you invest, not the number of shares you buy; you need to believe that 5,000 shares of a two-cent stock will grow $100 better than .03 of a share in Amazon.com. If Amazon, Disney, McDonald’s or even a GameStop are more appealing to your kids than some unknown company with shaky financials, they should make small investments in big names.

That may reduce the same potential to catch a rocket ship and double overnight, but they can still gain big and with less risk of going to zero.

From Dan in Baton Rouge, La.: I’m a high school teacher and my students were talking about the stock market because of all of the GameStop news. We discussed it in class and the children didn’t understand short selling and I didn’t know how to explain it to them. Could you explain short selling in a way that high school students would understand?

I can try, but rather than talk stocks, let’s talk prom dresses.

Let’s say the most stylish, trendy girl in school finds a designer dress that everyone loves and she buys it for $500.

The dress is so fashion-forward that it has been featured in teen magazines, making it hot now but leading you to believe that it’s about to go out of style; you think it will be old news by the time prom rolls around in May.

You convince the girl to give you the dress until she needs it (so she doesn’t have to tell her parents what she spent); you promise to get it back to her before the prom.

Then you go out and sell that girl’s dress to another stylish, trendy young lady for $500; now you have cash, but you still must live up to your promise to return the dress or you’ll be ruined socially.

Now, say you’re right about your fashion trends, and the style is fading. The dress is “so yesterday” on message boards, and starts being marked down in stores. By April, retailers are moving it to the clearance rack and selling it for $150.

You buy one at that price and give it to your friend. She has the dress, you have $350, your profit from selling the dress at a high price and correctly betting that it would decline in value in the future.

If, instead, the stylish/trendy girl is right and the dress remains the hot look and becomes even harder to find, it could cost you $750 or more to buy back; that’s how you could lose money on the deal.

If prom dresses aren’t the right example, adjust it to baseball cards, video games, smartphones or anything kids value; the idea is that short-selling is a way to invest when you believe the price of something will be going down.

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Chuck Jaffe is a nationally syndicated financial columnist and the host of “Money Life with Chuck Jaffe.” You can reach him at itschuckjaffe@gmail.com and tune in at moneylifeshow.com.