Why Robinhood Stopped Trading on GME

This will probably be my least popular post ever, but the explanation needs to get out there for why Robinhood stopped trading on GME.

Selling a stock short is NOT illegal. It is a perfectly valid type of investment according to the SEC:

“D. Are short sales legal?
Although the vast majority of short sales are legal, abusive short sale practices are illegal. For example, it is prohibited for any person to engage in a series of transactions in order to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others. Thus, short sales effected to manipulate the price of a stock are prohibited.”

Basically – you can’t short sell a stock to manipulate the price down so you can buy a lot more of it later. If you believe a stock is overpriced and short sell it, that is legal. That is exactly what tons of retail traders and hedge funds do every day, including on Gamestop.

On the other hand, manipulating a stock price upwards to cause a short squeeze IS illegal according to the same SEC article:

“Although some short squeezes may occur naturally in the market, a scheme to manipulate the price or availability of stock in order to cause a short squeeze is illegal.”

Unprecedented numbers of people on Reddit, Twitter, and elsewhere collaborated to intentionally create a short squeeze on GME in the last week. No one talked about a fundamental case why Gamestop the company was worth a lot of money and would be successful in the future; instead everyone made the argument that due to a very high short interest of 100%+, that a short squeeze would send the price “to the moon”. That is illegal according to the SEC.

Multiple brokerages, especially Robinhood, probably had their attorneys tell them that “Hey, you are aiding and abetting illegal activity by enabling a short squeeze and could be liable criminally or civilly if you continue to allow this blatant illegal activity on your platform”. So they decided to stop it by only allowing people to close their positions rather than open new ones in support of the short squeeze.

Another strong reason is that if the short squeeze caused the GME stock to go to 5000 in a sudden leap, tons of traders (both retail and professional) could instantly go broke, and then the brokerage (Robinhood) would be left holding the bag. For example, picture a retail investor with a Robinhood account had sold call options in the amount of $100,000 and their account was worth $200,000. If the price gapped from 300 to 5000 and those options were exercised, that trader could have a loss of $10,000,000. He would lose the value of his account, $200,000… but the brokerage would have to make up the rest of the settlement and take a loss of $9,800,000. Now multiply that by thousands of accounts…. no brokerage wants to take the risk of being bankrupted, so they shut it down.

The two strong reasons Robinhood and other brokers stopped trading was to prevent legal liability from enabling illegal activity on their platform, and for wanting to avoid potentially massive banktuptcy from traders unable to cover their losses.