'More fragile than people think': A Wall Street expert warns that the emerging 'species' of risk-loving day traders is threatening to upend an already-vulnerable stock market

  • Day-traders pose a threat to markets, argues Academy Securities' Peter Tchir.
  • He says their tendency to trade lots of options and relatively few but successful stocks are among the factors that make them a bigger driver of markets than people believe. 
  • He unpacks why investors ought not count out the impact of the low-capital traders.
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Since the much-hyped spike in day trading began earlier this year amid the pandemic, with new investors creating accounts with retail brokerages like Charles Schwab and Robinhood in large numbers, some on Wall Street have downplayed the significance of the movement.

These new investors simply do not have enough capital in the market to alter its movements, so the argument goes. A Barclays analysis in June showed Robinhood traders were not behind the market's rally since March. 

But that doesn't mean the day-trading craze hasn't had any impact on equity markets. 

In a recent note, Academy Securities' Head of Macro Strategy Peter Tchir said Wall Street should be treating more seriously what he calls a "new species" in the trading ecosystem. 

"Right now, anyone trying to trade this market needs to better understand this new species of trader. We need to anticipate their moves," Tchir said in the Sept. 1 note.

"They are definitely aggressive, but not infallible – or at least not all of them. When looking at charts, or doing any other type of analysis, we cannot ignore the potential impact from these traders."

His position essentially boils down to the fragility of trading algorithms to the unprecedented behavior of the new generation of day traders in a still-thin market. 

"I will concede that total capital is relatively small compared to the market cap of the entire market or to daily trading volumes," he said. "But, in a world where volumes are distorted by the frantic trading of algos, any real order flows may have a surprisingly large impact on prices."

He argued that this process is playing out in several ways, the first being the fact that they are increasingly trading options in high volumes, leveraging their positions. 

They also invest predominantly in a concentrated group of stocks, he said, adding that so far they have made the right bets. In June, Goldman Sachs strategists found that the most popular stocks among retail traders had outperformed hedge and mutual fund favorites since the market bottomed in March. 

Further, they have an appetite for long-shot, or out-of-money, call options — meaning that when they bet correctly, they generate more cash to re-invest than a passive investor would. 

Their success so far has also allowed them to generate a following of investors who pile into hot trades.

Tchir's argument that algorithms are "more fragile than people think" leads him to warn that their failure to adapt to new trends could have dire consequences.

"I've argued in the past that the market is like a 'machine learning triple pendulum'. The triple pendulum can be made to be vertical, and with a series of constant adjustments, only capable by machines, it can be kept in an upright position for a period of time. But that positioning is inherently unstable, and prone to complete collapse, before being reset," Tchir said. 

"So in a world where true depth of orders is low, machines are constantly racing each other to scalp fractions of a cent, assuming those algos work with the introduction of an entirely new species added to the mix, which seems dubious at best," he added.

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