The Wild West of Online Trading

The term Wild West has deep historical significance but is also used broadly to signify, as Merriam-Webster puts it, “… a period characterized by roughness and lawlessness.” That’s where I think we are right now with the melding of social media and the surge of people using online trading platforms like Robinhood. But isn’t confined to just one firm. The frontier is wild, and the law is too slow in catching up.

My industry is heavily regulated, but you wouldn’t know it by much of what’s posted online these days. I take industry rules seriously because they’re there for a reason, usually the result of shenanigans that cost people serious money. So I really look askance at unregulated “influencers” giving investment advice on social media platforms. Many of them cheapen the process, as if the decision to buy or sell a stock was like any other product review. Bad online purchases can be annoying and inconvenient but buying the overpriced stock of a silly company just because some bloke suggested it online could cost you bigtime. Simply put, lots of people are being taken advantage of right now and the regulators, the “law” of the Wild West, are wondering what to make of it all.

As you can imagine, I’m not the only financial planner who feels this way. But what to do about it? After all, many of us don’t play in the social media sandbox and easily get drowned out by all those talking heads on YouTube. Instead of joining them, maybe it’s better to educate one investor at a time.

Along those lines I’m doing something a little different this week. Sara Grillo, an industry insider, has written a good “explainer” piece to send to anyone who may be considering day trading. I usually remove imbedded hyperlinks from articles I post, but I’ve left them in this time as they provide further explanation on important topics like defining margin debt, what real stock analysis is, and so forth. The idea is that this piece could be a helpful tool for anyone getting started with trading and needs help (or maybe a reason not to start).

Let me also add that I don’t want to stop anyone from trading stocks if that’s what they genuinely want to do. Instead, I hope they do some homework and try to develop an understanding of how complicated it is and, hopefully, don’t go overboard with the dollars they invest. Ideally, a first trading account should be thought of like money being set aside for that trip to the casinos with friends. It’s fun money, money that you could lose without repercussions aside from feeling silly. Start out trading with more than that and you’re really asking for it.

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Online trading has become more risky

Online trading has become society’s newest form of gambling for young adults in our society. This is in part due to the rise of commission free trading by brokerages, as well as the high levels of margin available through certain platforms. All of this has elevated the role of trading from a hobby or pastime to an activity with the potential to ruin a person’s financial future – and in some cases, it unfortunately has.

The growth of social media, and the higher potential for influencers to make money from their followings has also played a role in encouraging risky, reckless investing behavior. There are many instances of this causing considerable damage to the investing public, including a young man who apparently killed himself after seeing a six-figure loss in his Robinhood account.

For these reasons, I encourage you to pass the following information on to your children, any young adult you know, or any individual that you know who may be participating in online trading. You may also refer them to the sources listed at the bottom of this article for further explanation of the concepts discussed.

How online influencers make money and the potential bias that goes along with it

Social media influencers are not always objective in their views. For all the following reasons, recommendations made on the internet may be highly biased to benefit the person making the call, and should not be assumed to be objective, independent, or made 100% in your favor.

Often social media influencers are motivated to talk about controversial topics or make exaggerated statements to attract attention and grow their followings. This is because many of them get paid higher advertising revenue for higher views on their posts.

Influencers may also earn money by encouraging their followers to buy products that they receive an affiliate payment, or kickback, on through use of affiliate links. Someone may say, for example, to click a link below their video to open an account at a certain brokerage firm for a discount so that they can make the trades mentioned in the person’s video. The following video shows an example of affiliate marketing.

Influencers may also benefit from you taking action on certain positions that they hold or intend to get involved with. If they hold a certain stock, they stand to benefit from massive buying action taken by others on the same position.  If they intend to buy a certain position, they will benefit from massive selling action on that security prior to purchase.

Influencers may neglect to fully disclose all the risks involved with making the investment to prompt followers to take action.

They also may cite impressive historical track records without providing legitimate verification of these performance results, again to encourage followers to take any action that will benefit them.

Many online influencers make their recommendations merely on the news and do not conduct proper research as to the fundamentals behind the position. Often these influencers are not licensed, regulated, or registered representatives of any securities firm. As a result, they are given significantly more freedom to discuss high risk recommendations without having to fully disclose the potential downside of any investments they are recommending.

Margin, shorting and unlimited potential for loss

Certain brokerage positions may offer you margin to potentially magnify the gains made from trading.  Trading on margin is a high-risk activity and you have the potential to lose substantial amounts of money if the market moves against you. Margin is defined as money borrowed from the brokerage firm you are trading with. In essence, you are getting a loan from the broker, one that is not forgivable under any circumstances and that you must pay interest on. Please refer to this description of how margin works from Charles Schwab.          

Short selling is a high-risk form of trading. You borrow a stock on margin and then sell it, with the understanding that you will buy it back. Your hope is that the stock drops in price so that you can profit from the difference between what you sold it for and what you bought it for. Because stocks have the potential to rise indefinitely in price, the potential for loss on a short position is unlimited. Please take precautions and understand the risks of short selling before doing so.

Responsible trading tips

Before you take advice from someone on the internet making an investment recommendation, ask yourself what they stand to gain by you taking the action they recommend.

Conduct your own research and consult numerous information sources with varying and opposing opinions on any particular position, including those by licensed, regulated professionals who are obligated to discuss in full each and every risk inherent in the investment.

Take the highest of precautions when investing in speculative stocks, engaging in short selling, or trading on margin, as the potential for loss is high and, in some cases, may be unlimited.

If you have any questions about what you are trading, stop and consult a qualified, licensed, and regulated financial professional before going through with the trade.

Always consider the maximum potential for loss and thoroughly research all the risks involved before initiating any trade.

Calculate your own margin and map out loss scenarios before trading. Always do your own margin calculations as you trade because the brokerage firm could make a mistake.

Here’s a link to Sara’s blog if you want to check out more of her content. A list of her sources for this piece are copied below as well.

https://saragrillo.com/2021/02/16/important-financial-advisors-talk-to-your-clients-about-robinhood-tiktok-reddit-and-their-kids-right-now/

Sources

Chang, Charlie. (2021, Jan 28th). The 6 TOP Stocks To Buy in February 2021 (High Growth). Retrieved from https://www.youtube.com/watch?v=Hz6EU_e34iI&t=10s

Egan, Matt. (2020, June 20th). CNN Business. Apparent suicide by 20-year-old Robinhood trader who saw a negative $730,000 balance prompts app to make changes. Retrieved from https://www.cnn.com/2020/06/19/business/robinhood-suicide-alex-kearns/index.html

Frederick, Randy. (2021, February 12). Margin: How does it work? Charles Schwab. Retrieved from https://www.schwab.com/resource-center/insights/content/margin-how-does-it-work.

Little, Ken. (2020, January 19th). Short selling stocks – not for the faint-hearted. Retrieved from https://www.thebalance.com/short-selling-stocks-not-for-the-faint-hearted-3140549

Singh, Manoj. (2021, Jan 9). Investopedia. How to become your own stock analyst. Retrieved from https://www.investopedia.com/articles/basics/09/become-your-own-stock-analyst.asp

Have questions? Ask me. I can help.

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