Imagine you could borrow an unlimited amount of money. You need USD $2000 collateral, but otherwise everything goes - no questions asked. Want to borrow $10k? Fine. $100k? No problems. A cool million? Absolutely, with pleasure.
This week’s article is exactly about this situation: Robinhood’s Infinite Leverage.
How much would you borrow? What would you do with the money?
Here’s one idea:
- borrow USD $50 000;
- buy AAPL covered put options;
- get to a ~$7 000 unrealized profit (yay 🎉); but then also
- hold on and lose $50 000 for a total of ($100 000) realized return.
Somebody actually did this. Very cool. And by very cool, I mean holy shit, why would you do this.
There is a YouTube video of the events unfolding a short time later. Take a look at the portfolio value change between 0:41 and 0:42.
Internet being what it is, some people saw this video and thought to themselves, I want this, except riskier.
How Did the Infinite Borrowing Work?
Here are three things you need to know:
- Robinhood offers a 2:1 margin. If you have $100 in cash, Robinhood will lend you $100, so you can buy a total of $200 of stuff;
- same if you have non-cash assets available. If you have $100 in Apple stock, Robinhood will float you $100 to buy some stuff;
- if you sell a call option, the premium will be added to your cash balance, but the stocks will not be excluded from your non-cash asset balance.
It might not be immediately obvious what’s happening here, so here’s a step by step example:
- initial state: CASH:$100 AMD:$0 MARGIN:$100;
- buy AMD stock: CASH:$0 AMD:$200 MARGIN:$0;
- sell AMD stock for let’s say 90% (strike price + premium). Robinhood and reality part ways here:
- real life: CASH:$80 AMD:$0 MARGIN:$80 (You have lost money! The strike price is $2 and the options are sure to be exercised);
- Robinhood, though, thinks your portfolio value just went up: CASH:$80 AMD:$200 MARGIN:$280;
- now you can buy some AMD for $360 (cash on hand + margin that Robinhood extends based on your imaginary portfolio value as collateral);
Notice (but don’t let it stop you, I guess) that at every iteration you are actually losing money.
Repeat the process until you reach your Personal Risk Tolerance™, and then plow everything into 358 AAPL covered puts, and hope for the best.
There was a fixed amount lost on the AMD contracts, and the ultimate upside/downside was dependent on AAPL movement. Because these were covered puts, the upside was limited, but the maximum downside was unlimited 🚀 (except instead of the moon, this rocket is burrowing into the ground).
This Explanation is Boring
Here is an admittedly better and more hilarious explanation. This one uses less finance terms, and more Reddit finance terms such as “line of white lightning”, and “cat lady”.
I suppose it ends in therapy for the people who lost 5 to 6 figures on this. For Robinhood, this ends with increased regulatory scrutiny.