Robinhood Stock Is Under Fire. Here’s How to Play It Now.

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Dreamstime

The party is over. Or maybe not.

At any given moment, the world’s most sophisticated trading firms, including Citadel Securities and Susquehanna Investment Group, are paying good money for orders from brokerages that cater to individual investors.

Some firms now pay as much as 40 cents per options contract, and fractions of a penny for stocks, to take the other side of trades. That allows brokerages like Robinhood Markets (ticker: HOOD) to charge zero trading commissions to their clients and many others to charge deeply discounted commissions.

The appeal of this arrangement to trading firms is that they have a guaranteed source of “dumb money” order flow that is profitable and easily hedged.

Payment for order flow, or PFOF, is a critical force for trading firms. Those who have PFOF relationships tend to prosper, and those who don’t tend to struggle for meaningful profitability. The goal is thus to trade with as much small-investor money as possible, starving competitors of the opportunity to interact with profitable trades.

SEC Chairman Gary Gensler recently told Barron’s that he was reviewing PFOF and might even try to ban the practice, which has been long condoned by the SEC. It all sounds ominous, but it’s hard to see a legal basis for banning PFOF if orders are executed at the best available price, which they generally are under the SEC-approved National Best Bid and Offer system.

Banning PFOF essentially means the SEC would be forced

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to confront a trading ecosystem that it has allowed to haphazardly evolve over the past 20 years as electronic trading has come to define the financial markets.

Nevertheless, shares of Robinhood, which makes about 80% of its revenue from order-flow payments, took a hit after Gensler’s Aug. 30 pronouncement. The stock closed down 6.9%, at $43.64, in reaction to the news, and it has since fallen even further.

Investing in Robinhood is a risky endeavor—but that makes it intriguing. Here’s an aggressively bullish trade to consider if you believe that banning PFOF would be much more difficult than many people realize: Buy Robinhood stock and sell weekly call options with strike prices that are at, or just above, the stock price.

With Robinhood at $40.05, you could sell the September $42 call that expires Sept. 17 for about 80 cents. On expiration Friday, or the day before, roll the call to the next weekly expiration at whatever strike price is needed to generate a credit. If you cannot get a credit one week out, pick another week.

The trade expresses the view that PFOF will be harder to kill than expected—and that Robinhood is more than an order-flow pimp. Even if PFOF were banned, Robinhood could probably get away with charging modest trading commissions.

The biggest risk is that the SEC manages to change the rules of the game and Robinhood stock plummets in price.

Robinhood has achieved something that was thought to be nearly impossible on Wall Street—making investing interesting to millennials who, Wall Street feared, had no interest in markets. For a glimpse into how it operates, check out Robinhood Snacks, the company’s daily financial news service, which links to the trading platform.

Robinhood’s skill in making investing accessible is often lost in the criticism that is leveled against the company for making investing seem like a casino game. The irony is that Wall Street’s trading community considers gambling skill to be a highly desirable trait. b

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.