Last summer, a small, unknown social media company called Cynk Technology experienced the kind of runup that is the stuff of Wall Street legend. In less than a month, its stock price rose from six cents to nearly $22 a share, an increase of more than 36,000 percent.
Cynk’s apotheosis came at a golden moment for social media valuations. A few months before, Whatsapp, founded in 2009, sold to Facebook for $19 billion. Snapchat, started by Stanford undergraduates in 2011, had recently turned down an offer of $3 billion. By such standards Cynk’s acutely vertical takeoff might have seemed almost normal, but it didn’t look quite right to the Securities and Exchange Commission.
What made the SEC question Cynk’s $6 billion valuation was its balance sheet. Promoted as a platform for connecting to the rich and famous, Cynk had no assets and no revenue; its offices were located at a non-existent address in Belize, and its only employee was its CEO, who now owned $3.5 billion in shares of a company that had no real value.
It seemed like a classic case of a penny-stock pump-and-dump, the illegal practice of buying a cheap stock, talking it up to get others to buy and raise the value, then dumping it, killing longs and shorts alike.
But in today’s financial landscape, the ascendance of the algorithm has reinvented the pump-and-dump. Every second, billions of dollars worth of stocks big and small exchange hands without much, if any, human involvement, and much of the pumping now comes by way of social media.
The Virtual Trading Floor
“Social media has become hugely important in stock trading,” says Mihir Dange, a former gold trader at the New York Mercantile Exchange, who now works with a company that integrates social media and markets. Twitter in particular, he says, was a game changer for both institutional investors and small-time traders alike.
“Before, you really needed to be someone to get news as it was happening,” he says. “Bloomberg terminals weren’t available for common people. If big changes happened in the marketplace you had no way to know what had happened until Bloomberg, the Wall Street Journal or any of the other big outlets wrote about it.”
But today, as CEOs circumvent traditional corporate communications to broadcast their views directly to the Twittersphere and studies that suggest that online popularity—from Twitter mentions to Facebook fans—correlates positively with stock performance, social media offers today’s investors a new and powerful barometer of a stock’s future.
Unfortunately, with newfound power comes newfound responsibility, and the vast and opaque social media landscape is riddled with as many new dangers as opportunities.
The SEC has warned that investors should beware of social media’s virtual trading floor: “Through social media, fraudsters can spread false or misleading information about a stock to large numbers of people with minimum effort and at a relatively low cost. They also conceal their true identities by acting anonymously or even impersonating credible sources of market information.”
These types of fraudsters are nothing new—history’s long list of stock market scammers proves that—but the venue they’ve entered is. As Keith McCullough, CEO at Hedgeye Risk Management, put it recently on CNBC: “Twitter pump-and-dump schemes are obviously something for the market to be concerned about, even if they are just a new way for people to do schemes that have been done forever."
And while people deposit half a billion tweets per day into the Twittersphere, today’s investors suffer from an overabundance of information—adding the challenge of finding the needle in the haystack to the already daunting task of knowing which of those needles can be trusted.
The Algorithmic Stock Market
The stock market has always been defined by knowing and acting on information before the rest of the market can keep up. But today, there’s a new player in the game that no one can keep up with.
High frequency trading (HFT), in which computer algorithms work at light-speed to trade shares at a rate of many thousands per second, accounts for roughly 50 percent of all stock market activity. The decisions made by these algorithms are based not only on the careful study of a company’s balance sheet but a host of other factors that can shift the markets, including, of course, social media.
With tools that can automatically glean sentiment analysis from Twitter’s firehose of information at rates a human investor can’t possibly match, HFT’s are almost always the first movers on a stock. But though new technology that analyzes the credibility of this information is emerging, these algorithms still fall victim to the same misinformation as humans—which is how stocks like Cynk Technologies can achieve growth rates in the quintuple digits in just a few weeks.
The combination of social media’s fallibility for pump-and-dumping and lightning-fast HFT algorithms in a market can snowball until either a completely worthless company is worth $6 billion or the entire market spirals into a crash, wiping out billions of dollars. This is what many believe happened in the “flash crash” of 2010, when the Dow Jones, for no obvious reason, dropped by almost 1000 points in five minutes.
Both tools, however, are still in their infancy.
HFT is the market’s answer to the question of how to manage the speed and volume of information on and off social media that can move the markets. And just like the real world, social media will always have its share of bad actors, but new tools like Dataminr and Ravenpack are emerging to give investors of all sizes ways to cut through the noise with confidence.
In the meantime, investors should, as always, beware. The stock market’s playing field has evolved—and, with social media, democratized—but the tried-and-true balance between risk and discretion will still determine its winners and losers.
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