Why Did Robinhood Shut Down GameStop Trading?

Robinhood users can sell GameStop shares, but they can't buy them. Find out why.

Robinhood is an online brokerage firm that prides itself on making it easy to buy and sell stocks. But if you're a user of this popular trading platform, you'd have found it impossible to buy a few specific stocks on Thursday.

Specifically, you wouldn't have been able to purchase shares of GameStop (NYSE: GME), AMC (NYSE: AMC); BlackBerry (NYSE: BB); Bed Bath & Beyond (Nasdaq: BBBY) or Nokia (NYSE: NOK) on Robinhood as of Jan. 28.

In a released statement, Robinhood provided a solid justification for shutting down trades of GameStop shares, as well as for trades of the other stocks mentioned. But many weren't satisfied with the brokerage's explanation for its actions, and Robinhood has now indicated it will change course, allowing limited purchasing of GameStop shares starting Friday.

Here's what you need to know.

Here's why Robinhood shut down GameStop trading

On Jan. 28, Robinhood suspended the ability to buy shares of GameStop. App users were allowed only to sell their positions, not open new ones or add to their existing holdings in GME.

The brokerage's statement explaining its actions read, "We continuously monitor the markets and make changes where necessary. In light of recent volatility, we are restricting transactions for certain securities to position closing only." The statement, which was posted on Robinhood's websiteand sent via email to its millions of users, also went on to say, "Amid significant market volatility, it's important as ever that we help customers stay informed."

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Robinhood wasn't exaggerating about the volatility of GameStop stock. Shares rose more than 1,800% during the month of January, and the price has fluctuated by hundreds of dollars per share in a single trading day. What makes this even more remarkable is that the company is a retailer that's largely considered outdated in the era of online sales, and prior to recent weeks, its share price was below $20.

There is, of course, an explanation for the stock buying frenzy that led to Robinhood's decision to shut down trading.

Users of a Reddit subforum called r/WallStreetBets decided to capitalize on the fact that GameStop is a favorite stock for hedge funds to short. With hedge funds betting big on the company's shares declining in value, Redditors opted to start buying -- thus driving the price of the stock up.

This created a "short squeeze," as those who were betting against GameStock had to buy stock to cover their shorts. The feedback loop led the price of GameStop to climb up quickly, especially as the Redditors encouraged buyers of GME shares to prohibit their shares from being lent to short sellers.

Wall Street hedge funds began losing big time as some individual investors claimed eye-popping profits with GameStock's share price going through the roof. But the fun came to an end when Robinhood shut down trades, preventing more investors from buying in, which in turn sent share prices tumbling back down to Earth.

While Robinhood may have indeed acted to protect its customers -- buying into GameStop under these conditions is undoubtedly risky -- many expressed concern that the broker was acting to protect Wall Street insiders from losses, rather than its customer base.

Lawmakers including progressive icon Alexandria Ocasio-Cortez and conservative firebrand Ted Cruz have called for hearings into Robinhood's decision, and some app users are calling for a class action against Robinhood, with one user tweeting, "Robinhood canceled stock orders on #gme #amc #NOK etc. ... There should be a class action lawsuit. I thought we had a free market. So Wall Street is OK with me losing hundreds of dollars, so that rich investors can't be called out on their risks.... #wallstreetbets."

Trading to resume on Robinhood on Friday

After a day of criticism on social media, Robinhood announced late on Thursday that it would lift its restrictions on Friday and allow at least limited trading of GameStop.

"Starting tomorrow, we plan to allow limited buys of these securities," the company said in a statement. It went on to indicate that "we’ll continue to monitor the situation and may make adjustments as needed.”

The brokerage justified its earlier actions based on SEC regulations for broker dealers, which they indicate "exist to protect investors and the markets and we take our responsibilities to comply with them seriously, including through the measures we have taken today.”

Finally, the company addressed the accusation that it acted to protect Wall Street, stating unequivocally that "this was a risk-management decision, and was not made on the direction of the market makers we route to. We’re beginning to open up trading for some of these securities in a responsible manner."

Still, while trading will resume on Friday, trading in GameStock remains a high-risk proposition, as the stock's current share price is not justified by the underlying business activity of the company. If you are considering using Robinhood or another brokerage to buy GameStop shares, make sure you understand the dangers of this type of trade.

Christy Bieber has no position in any of the stocks mentioned. The Motley Fool recommends BlackBerry. The Motley Fool has a disclosure policy.