Jun 28, 2024
Written by:
John McDowell
Meme stocks are shares of listed companies whose prices and trading volume are heavily influenced by the activity of retail traders on social media. These stocks are highly volatile, with their prices and trading volumes experiencing sudden hikes, due to social media hype and frenzy surrounding them. This means that price spikes are mostly the result of social media speculations instead of any change in the company’s fundamentals.
So what distinguishes meme stocks from traditional stocks apart from the social media impact? Here are some of the important characteristics of a meme stock that will help you identify whether or not a particular stock is a meme stock:
Meme stocks typically have low trading activity until the demand is spurred by social media sentiment around the stock. Bluechip or other well-known stocks have a good trading volume even on normal days. Because traditional stocks are popular, they are regularly covered by the press and mainstream media.
Meme stocks are mostly only covered in selected investing/trading groups on various social media platforms. Above-normal trading spikes in traditional stocks are usually not due to social media enthusiasm, but rather a result of significant news that impacts the bottom or top line of the company or a change in the company’s fundamentals.
Unlike traditional or blue-chip stocks that have strong fundamentals, most meme stocks are either unfamiliar names or have weak fundamentals. This is reflected in the lack of buying interest from large institutional investors, resulting in low trading volume for these stocks. Because of the low trading activity, meme stocks are prone to volatility as even the collective actions of retail investors can sway them, which is not possible in the case of blue chip or traditional stocks where market manipulation is difficult due to the active participation of large institutional investors.
Short interest denotes the number of shares that have been sold short and have been outstanding (unclosed positions). A short interest ratio, usually above 40%, is considered high and means that a significant number of market participants believe that the stock would go down and have made short bets on the price.
Meme stocks with high short interest are prone to short squeezes, which push the stock price further up after an initial price rise stimulated by social media retail investors. Traditional or blue chip stocks, in contrast, have low short interest and are less prone to market manipulation and phenomena like short squeezes.
Social media and meme stocks go hand in hand. They trend on different groups on various social media platforms, which often fuels a jump in demand for the stock, leading to trading volume and price spikes. For example, if you see that a company’s turnaround story, stock price prediction, stock recommendation, investment ideas, or short squeeze strategy has been excessively discussed on certain investing/trading-related groups on social media, it could be a signal that the stock will experience volatility as retail investors act in unison.
The most common social media platforms that retail traders use are Reddit, YouTube, X (formally Twitter), and Facebook, although other channels could also be used. The groups of individual traders are usually led by investing gurus who have a history of successfully predicting different stock rallies or have amassed fortunes from investing in meme stocks. Sometimes, even a simple message or a video posted by de facto leaders or social media influencers could translate into a significant movement in volume and stock price.
No matter what gurus will tell you on social media, we advise you to take everything with a grain of salt. Fundamental analysis may not come into play as it normally would. Social media is mostly the prime if not the only mover of such stocks. For example, if social media has hype surrounding the stock and touting a fancy turnaround story of a company as its potential price rises, you could probe the story to determine whether it makes any sense.
And if, despite the story behind the move, the stock’s volume and price rise, you could then decide whether to buy based on some sort of technical analysis, like support and resistance levels. However, you should decide quickly not to be too late in joining the trend because the early buyers could start unloading the stock to book their profits, which could send the stock crashing. So, the key is to watch if the stock is indeed doing what has been the sentiment on social media, and then join the trend soon enough to ride the trend.
Above is an example of how you could take advantage of the quick trend in the recent GME social media pump and dump. You could have caught the sideways pull-back and bought on the breakout annotated on the Tradingsim chart.
Social media users on Reddit and other similar platforms use plenty of jargon and abbreviations, each describing different situations in the investing/trading world. Knowing them can help you understand what is being said.
Here are some of the most common ones:
There have been many examples that show social media as the driving force behind the explosive and unprecedented surge in prices of ordinary companies with lackluster financials. Here we describe how retail investors from social media induced a short squeeze on two meme stocks: AMC Entertainment (AMC) and GameStop Corporation (GME).
AMC Entertainment (AMC), the largest movie chain in the world, had its stock subject to a short squeeze in 2021, executed by individual investors from groups on Reddit and Twitter. The stock had a considerably high short interest, particularly by different hedge funds, due to the overall dismal financial position of the company. At the start of 2021, the private retail investors on Reddit collectively decided to accumulate AMC shares as they believed the stock to be undervalued and wanted to push the price upward to carry out the short squeeze on the heavily shorted hedge funds.
At the start of January 2021, the stock was trading at just $2. After just five months on June 02, it reached around $73, which is a whopping 3,500% gain in just five months. The stock experienced several peaks and troughs during the five months, leapfrogging from $5 to $20 in a single session in January. The hedge funds, with high short positions, came under pressure and rushed to buy the shares to close their positions, which fueled the demand for the stock. Several hedge funds went bankrupt.
The fact that retail investors united by social media platforms could pull such a feat to bring large hedge funds to their knees became the talk of the town and was largely covered by the mainstream press and media.
GameStop is an American brick-and-mortar game retailer. Its stock, like AMC, underwent a short squeeze in January 2021. Due to the Covid-19 pandemic, the company’s sales declined due to lockdowns and stay-at-home orders by the government. This led many hedge funds to open short positions on the stock, with the short interest ratio reaching 140% on January 22, 2021.
At the same time, investors on social media forums and platforms had a notion that the stock was undervalued. Further, social media celebrity Keith Gill (also known as Roaring Kitty) would share updates on different platforms about how his investment in GameStop Corp. had been performing exceedingly well.
There had been active discussion about the stock’s unusually high short ratio on the Subreddit forum r/walltreetbets, which prompted many traders to buy the stock. After the demand for the stock picked up pace, the price started to rise and forced the hedge funds to close some of their positions. This only added to their woes as the abnormally high short interest was not sustainable and drove the prices higher.
Between January 4 to January 28, 2021, the stock had gained an astronomical 2,700%, rising from $4 to $120. Many hedge funds with large short trades suffered huge losses, with firms like Melvin Capital Management LP going bankrupt.
Meme stocks have the potential of giving you quick gains but they are equally risky as well. For example, if you enter the market at the wrong time, just when the prices have peaked, you might lose a significant amount of money. That is where efficient risk management and a research-backed strategy come into play. To trade meme stocks profitably and effectively, you need to be a part of large social forums such as Reddit r/wallstreetbets and closely monitor the prices of the stocks discussed there.
If you want to get some of the upside potential that meme stocks have to offer while reducing the risk that you take while investing in meme stocks, you should always employ risk management practices. This will ensure that you get the best of both worlds.
Another strategy is to allocate a smaller portion of your total portfolio to meme stocks so that your portfolio return could increase in case your investment in the meme stocks goes your way. And if the investment goes against your way, the other assets or stocks in your portfolio will make up for the losses in the meme stock investment.
Meme stocks have prices that are mostly detached from their fundamentals, and this is particularly true during times of high trading volume and volatility generated from social media hype. In such a scenario, even technical analysis would not prove helpful either. So, the best way to participate in the trading activity is to clearly understand why you want to buy the meme stock, what would be your exit point, and the minimum amount as a percentage of your account you are willing to risk on your trade.
Social media undoubtedly plays a major role in shaping meme stock prices. The successes of retail investors in 2021 using social media forums and networks have given rise to the meme stocks phenomenon. Social media has empowered retail investors who can turn the tide on hedge funds as was seen in numerous short squeezes in 2021. Individual traders now have access to all sorts of information and advanced trading platforms that they can use to trade using their phones.
Investors who are not savvy enough to understand fundamental or technical analysis and other complex trading strategies can do social trading as well, a feature that allows traders to copy others’ trades or match their portfolios. Alternatively, they can browse social media forums such as Reddit to identify the stocks that could potentially offer significant upside.
Although it’s better to form your own trading strategy and carry out fundamental or technical analysis to make your trades, this strategy mostly works with blue chip or other traditional stocks. The best way to practice this is through an advanced simulation platform. A simulator like Tradingsim could take your trading to the next level, ensuring that your trading strategy works most of the time and in different market situations.
With meme stocks, however, you could just take the plunge by joining the herd and expect to reap the profits. However, don't just put all your eggs in one basket. Adopt sound risk management principles, which will ensure that you don’t lose more money than you can afford while also having a chance to be a part of the explosive price runs.
Tags: Day Trading
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