When Keith “Roaring Kitty” Gill announced he was buying GameStop (NYSE:GME) shares and options on reddits r/WallStreetBets, regulators may have viewed his outrageous claims as parody — speech protected by First Amendment rights. Who could take a $20 call on GME seriously if the stock was trading at $5?
Since then, other social media forums have blurred the line between satire and deliberate deception. Share this week in SCWorks (NASDAQ:WORX) doubled after traders click disagreement and Twitter work together to raise prices. MINM, DTSS and an alphabet soup of other small-cap stocks have followed the same path
In other words, the Securities and Exchange Commission (SEC) has a problem: when does ‘swarm trading’ turn into market manipulation?
PULLING THE TEETH
The answer is clear as mud. The SEC has typically drawn a line between Jordan Belfort’s boiler room tactics (aka the Wolf of Wall Street) and sharing stock tips among friends and family. The former is considered market manipulation, while the latter is often the forgivable consequence of drinking too much alcohol at a family gathering.
But what happens when your friends have 65,000 fellow Discord merchants or 100,000 Twitter followers? By spreading unchecked stock tips far and wide, social media influencers are starting to look more like the hype machines of the 1980s than enlightened stock gurus at the family barbecue.
In today’s big talk, we’ll look at some of the factors the SEC will need to address, and what investors can do to protect themselves (and potentially benefit) from the new stock influencers. (Hint: the answer includes options trading)
PS I don’t have a Discord channel.
The Great Lecture: Social media and market manipulation
First of all, a disclaimer. SEC rules specifically prohibit market manipulation, which they define as:
The “deliberate or intentional conduct intended to mislead or deceive investors by controlling or artificially influencing the price of securities, or intentional interference with the free forces of supply and demand.”
Second, I have a professional problem with those who intentionally manipulate security prices. My articles have long been aimed at companies such as: XpressSpa (NASDAQ:XSPA), Lordstown (NASDAQ:TO DRIVE) and SOS Limited (NYSE:SOS) for misleading investors.
Finally, market manipulation is downright wrong. Most pump-and-dumps fall apart once the initial investors pull out, essentially making them pyramid schemes that run at the bottom of the chain.
However, we all know that the line between ‘social influence’ and ‘manipulation’ has been blurred lately. You and I can hop on StockVIP, a public Discord channel, post our best trading ideas (after buying the stock first) and watch prices rise as others jump in. And until SEC rules catch up with this new reality, social media manipulation will continue to pose as an acceptable practice.
THE MOMENTUM FEEDBACK LOOP
When the first “boiler rooms” started appearing in the 1960s, many focused on selling municipal bonds at high prices. These call banks would use high pressure selling tactics on inexperienced investors to generate money.
As trading became more widespread, some operators realized that they could buy shares of penny stocks, create buzz around the stock and cause a snowball effect of investor purchases. In other words, rising stock prices became his own best sales pitch.
Today, amateur investors don’t need an army of salespeople to move markets. By sharing ideas on social media, they can create miniature buying frenzy around the stocks they own.
Nowhere was this more evident than on Twitter this week. For those who followed us, every day saw a new one AMC (NYSE:AMC) hashtag starts trending — #AMCUndefeated, #APESNOTLEAVING, #AMCDAY and so on. It’s a tactic that has kept the company’s stock price above eight times the forward price-to-sales — 3.5 times higher than GameStop and six times higher than its competitor. Cinemark (NYSE:CNK).
Taking advantage of the limits of the law
Understandably, regulators have been slow to act. It’s one thing to sue a professional boiler room company for calling out unsuspecting buyers. And it’s quite another to go after a novice day trader who shares ALL-CAPS one-liners on Twitter (as much as all caps should be illegal).
Instead, the US legal system has forced the SEC to focus on the concentreren goals of these pumps. Year-to-date, regulators have suspended trading in 165 companies, up from 55 in the previous six months.
In a particularly egregious case, the SEC halted trading in the Electric car company (OTCMKTS:ELCR) after social media posts inflated shares by 2,500%. The penny stock would convert nearly half of its outstanding shares in one day.
However, these suspensions are largely symbolic. No action was taken against those who initially posted the misleading claims. And not only did the suspension start four months after the first pump – investors had already lost 82% of their initial stake – the trading freeze lasted only 11 days.
A QUESTION OF MORALITY
Once you learn to recognize market manipulation, you’ll find it almost everywhere where stocks are mentioned on social media.
Tactic #1: Pump and Dump
The most notable trick is to go long on a stock and then promote its earnings on social media. As more investors get in, initial investors can quietly cash out.
Tactic #2: Mark the Closure
A lesser-known tactic is to buy stocks either Bee the closure or, more recently, after the closure. (This has become a common practice among Robinhood traders, many of whom do their trades after their business day has ended). By moving stocks at these critical times, these investors are unconsciously sending positive signals to the market.
Tactic #3: Market Dominance
Finally, investors can hijack a stock when enough people buy. By controlling the float of a barely traded stock, traders can act as market makers of past years and ask for any price they want. Short squeezes and gamma squeezes are common outcomes.
MAKE MONEY WITH MARKET MANIPULATION
Here I hesitate. Like an aviation mechanic who knows how to circumvent safety protocols, learning how to trade manipulated stocks can end in regulatory disaster.
Yet we now live in a world of NewEgg (NASDAQ:NEGG) and other highly manipulated stocks. No rational investor would value a stagnant, money-losing ecommerce business at 40x the price-to-sale value (let alone 100x). But that’s exactly what investors did to NEGG last week.
So for those who want to make big profits, I recommend keeping an eye on StockTwits and Discord. High-volatility stocks like AMC Entertainment tend to undervalue calls versus puts, making call options unusually attractive compared to their bearish siblings.
VCVC $15 belt, February 2022. At $0.225 per contract, these out-of-the-money calls are a one-sided bet on a potential pump by electric vehicle bulls.
AAL $25 calling, January 2022. Social media’s most-watched airline trades at 0.45x price-to-sale, the cheapest of any major airline. And if the $1.22 premium seems too high, DAL $50 calls will more than offset the amount.
GEO $10 calling, January 2022. Geo’s 75% implied volatility undervalues short squeeze potential. Investors who don’t want to risk losing theta may want to consider selling a $14 equivalent to rival CoreCivic.
(Note: Writing calls is besides risky and required daily monitoring. Learn to manage your risk here.)
Another alternative is to use abbreviated Momentum Master strategies to detect breakout stocks on social media. This week has seen gems like red cat (NASDAQ:RCAT) rise on its acquisition of Teal Drones, one of four U.S. UAV companies approved to sell to the U.S. military. Tap Life (OTCMKTS:TLIFE) was another winner after a “whale” buyer sparked online rumors of a HUMBL-esque backdoor listing.
Today’s downward market momentum means that only low-quality pink-leaf stocks are the Momentum Master strategies. Keep reading the Moonshot Investor for more recommendations next week.
Final Thoughts: Social Media and Moonshot Investing
Moonshot investors used to have two choices. On the one hand, you could buy a basket of stocks in an industry with a lot of potential, such as gene editing, and stick with it for half a decade. Anyone who does that with Crispr Therapeutics (NASDAQ:CRSP) would have earned a nice return of 550%; the next five years look equally promising.
On the other hand, you could use leverage to increase arbitrage profits. Howard Bancorp’s (NASDAQ:HBMD) recently announced merger with First National Bank (NYSE:FNB) trades 1.8 shares of FNB for each share of HBMD. That values HBMD at $21, or 6% higher than current prices, a delta that merger arbitrage investors will no doubt enjoy.
Today there is a third choice: taking advantage of less experienced investors. The social media trail is creating market inefficiencies so staggering that analysts from Bank of America to Citi are now refusing to cover many of these meme stocks.
But whether you decide to take advantage of market manipulation is up to you. It’s a brave new world that regulators haven’t quite grasped yet. And it leaves an unprecedented trail of gains and losses.
Questions or remarks? Connect with Tom at LinkedIn.
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Tom Yeung had no positions (directly or indirectly) in the securities referred to in this article on the date of publication.
Tom Yeung, CFA, is a registered investment advisor with a mission to bring simplicity to the world of investing.
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