Robinhood's Lucrative Options-Trading Platform Attracts Mounting Scrutiny
(Bloomberg) -- As one beleaguered stock after another suddenly soared in January, so too did queries on Google: “How to trade options on Robinhood.”
Robinhood Markets’s options-trading platform, barely three years old, is charting a meteoric rise in the Covid-19 pandemic, establishing the firm as the venue of choice for throngs of retail investing enthusiasts.
New disclosures show the app’s monthly volume of options executed tripled last year, making the firm the second-most active among peers behind Charles Schwab Corp., a 50-year-old stalwart that just bought TD Ameritrade. Offering options is so lucrative that they accounted for two-thirds of Robinhood’s reported revenue from order flow, a significant source of income. A single contract can generate more money than handling 100 shares.
But with that windfall comes mounting scrutiny of the role no-fee brokerages played in January’s chaos and how stringently they vet newbies eager to make options trades, which can amplify returns but also exacerbate swings in market prices. Skeptics, lawmakers and regulators have been aiming pointed questions at Robinhood.
Using its app, clients can unlock Robinhood’s most advanced level of options strategies in minutes by tapping their details into a smartphone. They can then instantly start placing wagers on some of the most complex U.S. markets available to the investing public. Approval for similar access can take days at competitors such as Schwab and Morgan Stanley’s E*Trade.
Concerns about Robinhood’s screening of options investors arose following news in June of the suicide of a 20-year-old user, after he saw a more-than $700,000 negative balance while using the app to bet on the contracts, according to an account by a family member. The tragedy stirred a debate over whether Robinhood was letting clients take risks they didn’t comprehend, prompting U.S. lawmakers to send a letter underscoring its responsibility to safeguard investing rookies.
Then in December, a Massachusetts financial watchdog blasted Robinhood’s screening of options applicants in a complaint the firm disputes. The office, overseen by Secretary of the Commonwealth William Galvin, accused Robinhood of encouraging the “gamification” of investing and said that when it comes to enabling options, the brokerage failed to ensure clients met its own criteria.
“Robinhood inappropriately, and in violation of company policy, approved customers for options trading despite those customers having no investment experience,” the regulator wrote in an administrative complaint.
In a 50-page response to Galvin’s complaint last week, Robinhood said the office misunderstood the firm’s criteria for approval and that customers can be granted access if they say they have prior experience trading options. “When that information is considered, Robinhood believes all Massachusetts customers met the applicable options-trading criteria,” lawyers for the company wrote.
Robinhood is “committed to providing the best investing experience,” the brokerage said in an emailed response to questions for this story. “While options trading is not unique to Robinhood, we’re proud to offer an intuitive and cost-effective platform to help people understand and trade options, including enhanced educational materials.”
Options contracts give holders the right to buy or sell a stock at a specific price by a future date. The derivatives can be more lucrative than transacting in shares directly. That’s because the value of contracts can multiply while underlying stocks rise by mere percentage points. However, if shares don’t move as hoped, the contracts remain “out of the money” and can end up worthless.
That danger, and the use of options in more complex strategies, are why industry regulators require brokerages to vet their customers. Firms typically adopt a system of risk levels, granting investors access based on factors including wealth and experience.
‘You’re Level 3!’
The popularity of Robinhood’s options platform exploded last year as millions of people opened accounts at the brokerage to pass time and earn money during lockdowns. By December, the monthly volume of contracts executed on its platform jumped 197% from the start of the year, dwarfing the 54% increase on Schwab and TD’s platforms combined, as well as a 46% rise at E*Trade, according to data compiled by Bloomberg Intelligence from regulatory filings.
The nominal increase in that activity at Robinhood also outpaced other firms, the data show.
Applying for access to options on Robinhood’s app is relatively frictionless. After tapping “continue” on a few screens and setting profile parameters such as income and risk tolerance, the app greets entrants to its most advanced level with a green fireworks graphic and congratulatory message: “You’re Level 3! You can now trade vertical spreads, calendar spreads, iron condors and more.”
In the Massachusetts complaint, Galvin said the firm granted more than 48,000 customers in his state some level of ability to trade options even though they had little or no investment experience. Robinhood wrote in its response that many customers approved for options don’t go on to trade them. While the firm has automated approvals, that system is overseen by a human, and afterward customers “are subject to review through manual spot checks,” the company said.
Schwab, in contrast, says it deliberately takes time to vet customers. Applicants for every risk level must submit a form online or by mail for review by company personnel.
“We’ve taken a conservative approach,” said Jeff Chiappetta, vice president of trading and education at Schwab. Approval won’t come “today or tomorrow,” he said. “There is a little bit of a time lapse.”
Still, its TD Ameritrade business has automated at least some parts of the vetting process. The firm says humans are involved in reviewing permission for advanced options trading.
Financial watchdogs are ramping up scrutiny of retail investing after traders on Reddit and social media sent shares of GameStop Corp. and other companies skyrocketing in recent weeks, burning some hedge funds. Treasury Secretary Janet Yellen plans to meet with regulators Thursday to discuss the tumult’s implications for market efficiency and investor protection. Options trading is expected to face examination after the Securities and Exchange Commission vowed to root out any market manipulation.
While options don’t drive prices in normal conditions, they can amplify sudden jumps if market makers deluged with orders for the contracts rush to hedge themselves against losses by buying shares. Over the past 10 days, an average of 1.1 million GameStop options contracts traded daily, more than 22 times what was typical in 2020.
“Unquestionably, Robinhood has made it easy for ordinary people to open accounts, trade complex financial products and take significant financial risks -- but what are the consequences for investors and the markets overall?” said Tyler Gellasch, executive director of the Healthy Markets Association, an industry group representing large investors. “The SEC, exchanges and Congress are about to spend a lot of time really examining these issues.”
To be sure, there’s no public data showing how much specific brokerages were involved in options trades tied to GameStop and other volatile stocks. But there’s no doubt Robinhood’s users were betting on the surges.
A variety of Google searches for trading options on Robinhood spiked to 12-month peaks in January. And an analysis by Atom Finance, an investment researcher, shows more than half of Atom users who traded at Robinhood on Jan. 27 were active in the volatile stocks the brokerage ended up restricting one day later. When Robinhood set out to reduce its exposure to those swings, it set limits on options contracts tied to those shares for days.
Robinhood makes money on options by selling orders to high-speed traders, a common industry practice.
Under the hood, its platform earned an average of about 64 cents per options contract executed in December, according to the data compiled by Bloomberg Intelligence -- more than most major brokerages. In comparison, Robinhood earned about 36 cents for every 100 shares of S&P 500 companies that month.
That’s made the burgeoning options platform key to the firm’s earnings. Options trading accounted for $440 million, or roughly two-thirds, of the company’s order-flow revenue from equities bets last year, Bloomberg Intelligence data show. The firm earns money in other ways too, such as from stock lending and subscriptions to its premium service.
“The brilliance of Robinhood is they’ve created software that’s easy to use,” said Burton Malkiel, a professor emeritus of economics at Princeton University, who also serves as chief investment officer at robo adviser Wealthfront, another financial-technology firm. “They’ve been probably most successful in attracting these people who are swept up in the gambling pandemic.”
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