Understand the Significant Risks of Short-Term Trading Based on Social Media
(STL.News) The SEC’s Office of Investor Education and Advocacy warns investors of the significant risks of short-term investing based on social media, especially in volatile markets, and provides tips for long-term investing.
Retail investors may seek to profit from volatile markets by buying individual stock, including stock in heavily-promoted companies with smaller market capitalizations. Some of these stocks may be discussed in social media, news aggregators, investment research websites, online investment newsletters, ratings websites, message boards, chat rooms, and discussion forums. It can be tempting to jump on the bandwagon and follow whatever the crowd seems to be doing. Sometimes, however, following the crowd may lead to significant investment losses.
Retail investors should understand that all investments have risk, and that short-term investing in a volatile market carries significant risk of loss.
Short-term trading, including trading aided by the use of margin or options, can lead to significant and unanticipated losses for retail investors. A Library of Congress report identified several investing behaviors that can undermine investment performance, including behaviors that involve short-term investing. Investors should keep in mind these behaviors when considering investing in a volatile market, including:
- Investing in Bubbles or Manias. Financial “manias” or a “bubble” is the rapid rise in the price of an investment, reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects. This rapid rise is usually followed by a contraction in the investment’s price. The contraction, or “panic” occurs when there is wide-scale selling of the investment that causes a sharp decline in the investment’s price.
- Momentum Investing. Another investing strategy that can pose high risks for retail investors is “momentum investing.” An investor using a momentum investing strategy seeks to capitalize on the continuance of existing trends in the market. A momentum investor believes that large increases in the price of an investment will be followed by additional gains and vice versa for declining values. If that belief turns out to be incorrect, it can lead to significant losses.
- Noise Trading. A third related strategy is “noise trading.” Noise trading occurs when an investor makes a decision to buy or sell an investment without the use of fundamental data (that is, economic, financial, and other qualitative or quantitative data that can affect the value of the investment). Noise traders generally have poor timing, follow trends, and overreact to good and bad news in the market.
Be careful investing with margin, options, or short sales.
All investing has risks. If you invest using margin, options, or short sales these risks may be magnified. Margin trading (using borrowed money to buy securities) can be very risky and is not appropriate for every investor. Before you invest using margin consider that:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses (a “margin call”); and
- Your brokerage firm can increase its margin requirements at any time and is not required to provide you with advance notice.
For more information on margin trading and its risks read our investor bulletins: “Understanding Margin Accounts” and “Margin Rules for Day Trading.”
Options (contracts to buy or sell a stock for a specified price on or before a certain date) like other securities carry no guarantees. Investors should be aware that it is possible to lose all of your initial investment, and sometimes more. Option holders (buyers of option contracts) risk the entire amount of the premium paid to purchase the option. If a holder’s option expires “out-of-the-money” the entire premium will be lost. Option writers (sellers of option contracts) may carry an even higher level of risk since certain types of options contracts can expose writers to unlimited potential losses. For additional information on options trading and its risks, read our investor bulletin “An Introduction to Options.”
Short sales involve the sale of a stock you do not own (or borrow for delivery). Short sellers believe the price of a stock will fall. If the price falls, short sellers buy the stock back at the lower price and make a profit. However, if the price of the stock rises, short sellers will incur a loss when they have to buy the stock back at a higher price. Short sales can expose an investor to the possibility of unlimited losses, since a stock can theoretically keep rising indefinitely. For additional information on short sales, read our investor bulletin “An Introduction to Short Sales.”
Market and broker-dealer protections for volatile stocks
The national securities exchanges and FINRA have rules designed to address market volatility in stocks listed on a national securities exchange. The “Limit up-Limit Down” rules are designed to prevent trades in these stocks from occurring outside a specified price band. This price band is set at a percentage level above and below the average price of the stock over the immediately preceding five-minute trading period. If a stock’s price moves outside these price bands for more than 15 seconds, trading in the stock will be paused for five minutes. For additional information on the “Limit Up-Limit Down” rules, read our investor bulletin: “Measures to Address Market Volatility.”
Also, broker-dealers may reserve the ability to reject or limit customer transactions. This may be done for legal, compliance, or risk management reasons, and is typically discussed in the customer account agreement. In certain circumstances, broker-dealers may determine not to accept orders where a transaction presents certain associated compliance or legal risks.
Be aware of the potential for market manipulation on online platforms.
Fraudsters can use online platforms (including social news aggregators, investment research websites, online investment newsletters, ratings websites, message boards, chat rooms, and discussion forums) to spread false or misleading information. Fraudsters may try to manipulate a company’s stock price (either positively or negatively) and to profit at investors’ expense.
For example, in a pump and dump scheme, fraudsters pump up a company’s stock price by making false and misleading statements to create a buying frenzy, and then sell shares at the pumped up price. In other instances, fraudsters start negative rumors urging investors to sell their shares so that the stock price plummets and then the fraudsters take advantage of buying shares at the artificially low price.
We urge investors to consider these long-term investing tips:
- Know your time horizon for investing. Often, information you read online about specific stocks can be short-term in nature. It focuses on events that may have an immediate impact on investments. Focus on long-term goals, and consider the benefits of diversification and asset allocation.
- Create and follow a financial plan. Real-time discussion platforms and buy/sell indicators driven by social sentiment may lead you to make emotionally-driven or impulsive investment decisions, which can be a risky way to approach investing. Do not let short-term emotions about investments disrupt your long-term financial objectives. If you are considering short-term investments, think about how much of your overall portfolio you should allocate to these types of investments.
- Be careful when investing based on information received on social media. While online platforms may provide useful investment information, use extreme caution when making investment decisions based solely on information found on social media platforms.
- Never feel pressured to invest right away. Before investing your money, research the company thoroughly. Make sure you understand its business and carefully review publicly disclosed company information. Take your time researching and making any investment decision.