Market Ecology And The New Species Of Retail Traders

Comments on: Zero-Commission Individual Investors, High Frequency Traders, and Stock Market Quality


Considering my last essay essentially talked about strategies that let you make the markets more efficient vs the ones that actually let you win, it's only fitting that I explore the further problems with looking at retail investors using terrible strategies to take rocketships to the moon. As much as I tried to stay out, the whole Gamestop saga did pull me back in!

To start with, did you know that retail investors now account for roughly 20% of stock-market activity on average and nearly one-quarter of trades on peak days, up from 10% in 2019?

Part of the argument being made in the CNBC circles is that this is a terrible thing. The increase in retail investors helps nobody. They run up insane stocks and buy on hope and prayers, unlike the hardnosed analyses that the market needs. And they're uninformed and easily swayed, and completely screws up the valuable information gathering aspects of the market.

There were multiple articles written about how the retail investors were fleeced, how they were coming together in droves to teach Wall Street a lesson and drove the stock way up.

Enter the paper from Eaton, Green, Roseman and Wu that came out recently, with the catchy title Zero-Commission Individual Investors, High Frequency Traders, and Stock Market Quality. Their abstract starts:

Contrasting with recent evidence that retail traders are informed, we find that Robinhood ownership changes are unrelated with future returns, suggesting that zero-commission investors behave as noise traders. ... Exogenous negative shocks to Robinhood participation are associated with increased market liquidity and lower return volatility among stocks favored by Robinhood investors, as proxied by WallStreetBets mentions. HFTs with Robinhood order flow arrangements quote narrower lit-market spreads during outages, and market depth order imbalances fall, suggesting that zero-commission investors create liquidity-reducing inventory risks for market makers.

They reach the conclusion that the new gen retail investors, who specialise in "zero commission trading" (read Robinhood and its ilk) are pretty crap in their ability to make sense of the market and provide mostly noise to the overarching Mr. Market brain that collectively determines prices.

The paper assesses two core questions:

  1. Are the new gen of retail investors, who dabble in zero commission trading apps like Robinhood, "noise" traders, and how does this impact market efficiency and liquidity? If the Robinhood traders are just another form of retail trader, presumably their behaviour should be similar, and have net positive impact on the market.

  2. Does the mediation by High Frequency Traders, through the Payment for Order Flow, change this? They're canonically said to reduce bid-ask spreads and increase price efficiency, though some voices suggest they also increase short term volatility, though this normally points to the Flash Crash.

The paper goes about answering this question rather cleverly, by identifying times when Robinhood had outages, and assessing the trading volume, bid-ask spreads and volatility of the main stocks that forums like r/wallstreetbets discussed.

(And just for clarity, they did it in the periods before Gamestop became a worldwide meme and irrevocably added stonk to our vocabulary.)

Once they validate that Robinhood platform outages are associated with reduced trading activity (outages are associated with 6.2% fewer trades), and the measures of market quality improve (price impacts 1 basis points lower) and lower volatility (17bp transaction price volatility with a mean of 240bp).

So maybe looks like wsb shouldn't get too happy, in that they seem to have mostly made things worse?


Since this seemed pretty odd, I figured I'd ask a few questions to the authors, who were inordinately kind and responded. Below were my main hypotheses re this phenomenon, and the answers in bullet points.

The stocks selected by the WSB group aren't a random sample, but rather actively selected. The bias that makes them get selected also help increase the market volatility etc when not being actively traded (since they're essentially creating marginal demand for some of those stocks)

  • To study the effects of outages, we need a measure of which stocks RH investors would have traded if they could. Of course it’s likely that RH investors also would have traded other stocks besides WSB stocks, but if relatively few RH investors traded them, the effects of the outage would have a minimal effect. The way we control for the fact that WSB stocks could have higher volatility, etc. in general is to compare market conditions during outages to the same time of day for the same stock over the previous five days. We use a difference-in-difference approach which also controls for the fact that market conditions could be different on average (by comparing the change in conditions to the change for non WSB stocks).

  • Another thing we do to try to address the concern that market conditions cause the outage is to redo the results for pseudo events assumed to occur one hour after the actual outage. As long as the market news is not super short lived, they should influence trading throughout the day. However, we only find effects during RH outages and not during pseudo outages, which we feel suggests the results are not spurious. Something we’re currently working on is looking specifically at the subset of brief (15-minute) outages and examining market conditions before, during, and after the outage. Early evidence suggests that market conditions change just during the 15 minute window.

The vol might come not just from the stocks but also from the high spread options trading that RH helps with, which creates market instability

  • It’s definitely true that option markets could magnify the effects of RH outages on equity markets. If we had intraday option market data we would explore that idea (but intraday option data is relatively hard to come by for academics).

Some of the outages coincided with crazy runs, like with GME et al recently, which could skew the overall results you've shown in the paper - eg I'm sure RH being out helped make the GME market more stable but I'm not sure we can draw overall conclusions from this

  • Our study ends in August when Robinhood stopped making aggregate ownership information public. But your point that the findings could be driven by a small number of stocks is still relevant. One way we try to get at this issue is to remove stocks that have a big increase in WSB mentions on the day of the outage. For example, if RH investors get excited about Hertz and buy the stock in droves which crashes RH, this outage will also influence other stocks as well. So we throw out Hertz (by removing stocks with a large increases in WSB mentions on the day of the outage) and study the effects of the outage on other WSB stocks. Our findings still hold up with the robustness check.

RH traders also have a long bias, and it's very possible that the removal of that bias from the market helps create some balance, and ergo, less

  • We haven’t explored directional trading much yet (i.e. we focus on absolute changes in ownership rather than buying or selling), but it’s on the list of things to do.

Also all of this is with the backdrop of 2020, high retail volumes (25% instead of avg 10-15 before),

  • It’s possible that many new investors will stop trading if the market falls. Our findings will still potentially be relevant for the next market upturn that draws in inexperienced investors (or for stocks that inexperienced traders particularly like)

I also wonder how much of the "regular retail" vs "WSB robin hood" trader diff is one of noise vs predictability - wsb signals its intent from the rooftops - naturally that'll impact markets when they play

  • It would be great if we distinguish between the effects of “regular” retail traders and RH-type retail traders on financial markets. There have been some outages at other brokers, but we don’t have the equivalent of WSB stocks to focus on for regular retail investors. It’s harder to know which stocks should be effected when regular retail investors can’t trade. I have another paper that suggests that “regular” retail investors become informed by reading Seeking Alpha, but these articles likely do not have as big an effect on regular retail traders as WSB does for RH investors.


The arguments made make sense overall, though they still leave some holes in the actual process by which the markets evolve. The first complication is that the facts are against any indication that the retail traders push together in one direction re their ownership, like so many synchronous schools of fish. Matt Levine notes, referencing the situation the market makers found themselves in:

That stereotype of new-style Robinhood trading might just be wrong. Even in one of the wildest melt-ups in stock-market memory, the absolute epitome of insane one-way retail buying, actual retail order flow was pretty balanced. People were buying, people were selling, it was fine, you could still make money trading with them.

For instance, here's the Citadel Securities' retail flow for one of the crazy weeks, from Matt's article.

That really doesn't look much like diamond hands to me!

If it's the case that the crazy rides in AMC and GME was sparked by retail investors, the craziness was also exacerbated because of institutional interest, that complicates the story. (Also I'm not sure Chewy's Ryan Cohen joining the board counts as either, but that's a separate topic.) If this is the case, that retail investors sparked the rally and then the institutional investors kind of figured it out and mauled everyone else as they usually do, perhaps the fact that things looked better during the times when retail wasn't trading should be seen as a bad sign?

Retail investors in this instance were very much "Robinhood-ing" the institutions, which would be quite satisfying I imagine to the wsb crowd.

The second complication of this argument is that the research also indicates retail investors are great for the market. They're mostly uncorrelated, unlike big hedge funds or mutual funds, in that they (usually) don't make coordinated buy or sell decisions, which is why Citadel pays themfor the privilege of executing their orders.

This is also why it seems that having large numbers of retail investors is a pretty good indicator of quality. For instance, Kelley and Tetlock (no, not that Tetlock) indicate that aggressive net buying by retail investors positively predicts firms' monthly stock returns. They're not alone, there's a rich vein of empirical analysis in a similar fashion.

So we have a hypothesis that retail investors are by and large noise traders who only muck things up when they enter the market en masse. And a couple very interesting lines of evidence - a) that they still trade in a pretty balanced fashion, all things considered, and b) that their trading might even be indicative of quality.

What’s also true is that the market has its own ecology. This has been studied empirically in a few ways, with the best approach I've seen in this paper that studied daily trading decisions of all Finnish investors in Nokia over 15 years. It said that the movements:

suggest that an ecology of investors is present in financial markets and that groups of traders are always competing, adopting, using and eventually discarding new investment strategies

Another key paper in the genre, J Doyne Farmer's assessment of market ecology, also shows how the different trading strategies co-evolve with each other.

We study a toy model of a market consisting of value investors, trend followers and noise traders. We show that the average returns of strategies are strongly density dependent, i.e. they depend on the wealth invested in each strategy at any given time. ... Market ecology, in contrast, provides insight into how and why markets deviate from efficiency, and what the consequences of this are. It can be used to explain the time dependence in the returns of trading strategies, and in some cases it can be used to explain market malfunctions.

From this view of the world, the entry of a new type of noise trader, in the form of zero commission retail trader, should create some fluctuations in the market. So the increase in spreads resulting from the emergence of new trading strategies or new market participants is perhaps to be expected, and not necessarily a sign of inefficiency or disequilibrium.

My sympathies are to this later argument. I'm not sure how systemic this problem is, vs it being something that's true at this point because we have a new shiny toy to play with. Whenever there are new methods of trading in the market, especially ones that change the dynamic by introducing "zero cost", you would naturally tend to see bubbles of odd behaviour until the impacts of the technology gets fully internalised.

Schwab, for instance, has already learnt from the competition provided by Robinhood, and also provides free trades. However it's clientele, built over decades, are much older and more sophisticated. Do they exhibit the same behaviour as the "uninformed participants"? Not really. It seems it’s not the tool of choice that creates the dynamics as much as the introduction of a new “species”. As a customer who uses Schwab and Robinhood, I can safely say I haven't done much "rocketship to the moon" on either, unless holding Microsoft counts.

The crossover between retail investors that others have studied and the zero commission investors seem to be rather fluid and fungible. These groups might have slightly different identities today, or in 2020, but they have significant crossover, and will continue to have that while the new methods of trading and platforms grow. Not to mention the fact that now we're all zero commission traders, ever since the major brokers all cancelled their fees.

And secondly, as Matt Levine's article noted, the retail investor behaviour seen in aggregate is still relatively randomly distributed, with the knock on effects being that of institutional interest fanning the flame. What this indicates is that it's not the "rocketship to the moon" traders that's necessarily causing the problems, but the smart money folks who see that and say, yeah let's pour some fuel and go along for the ride!

So when the conclusion states the following, I feel like they are overstating the differences.

Taken together, the findings support the view that the popularity of zero-commission brokers has attracted a new type of uninformed equity market participant that in aggregate has negative effects on market quality.

While the traders studied here present a few clear characteristics, they're also newer to the market and using tools that weren't present before. When the cost of something goes to zero, the behaviours get more volatile, and we've seen that behaviour before with telco (use of voice and data) for example. This seems like another case in point.

What the paper shows us is the complex dynamics that sit behind the retail trader ecosystem and how information actually flows through the network.

Ultimately I see this as a change in market dynamics as new trading strategies and new market entrants coincide. So while the zero commission uninformed retail traders might have had shaky impacts on the market, they've also been led by the likes of Roaring Kitty in a contrarian investment thesis which, whatever it's flaws, isn't simply "uninformed" or "noisy". If GME manages to execute its incredible ecommerce turnaround I wonder if we'll call those who saw the top geniuses instead. Instead their supposed herd behaviour is noted by the smart money traders who make it a self fulfilling strategy.

Like most "shore up the bottom" strategies this is ultimately likely to result in an alpha reduction and increase in market efficiency, in the medium run once the rush of the new entrants wears off, but I'm sure someone will find a new strategy by then, bringing volatility and widening spreads back. One can only hope, because that's an indication that Mr Market is getting smarter.

In either case this paper one of the few glimpses we've gotten of the entry of a new market participant, prior to their eventual assimilation into the trader ecosystem. To understand the difference the entry of new participants in the market makes, it’s probably worth trying to understand how they are similar or different to the other retail investors, and not just look at their immediate effects on market efficiency metrics. Even if they are at the beginning stages of getting to grips with the market, it might just be the growing pains that all groups go through, and we're just the lucky ones to possibly see it in such spectacular fashion.