Jun 25, 2024
Written by:
John McDowell
Meme stocks are shares of a company that experience a sudden and rapid rise in trading volume and price due to social media sentiment. Social media websites, such as YouTube, Facebook, Reddit, X, and others build discourse and positive opinions about a particular stock, prompting enough buying activity by a large number of individual investors to spike the prices and trading activity of the stocks. The resulting price rise is neither justifiable by the company’s fundamentals nor the stock’s technical analysis, indicating a price bubble.
In this post, we explain the usual characteristics of meme stocks, the factors that influence their prices, the investment strategies to invest in them, and some tips and insights that will help you make the most of your investment.
On one end of the spectrum, there are blue-chip and common household name stocks, the ones that you routinely hear or read about in the press and on television. Meme stocks, in contrast, are the stocks of lesser-known companies, often touted on social media as the new would-be Apple, Facebook, or Amazon that pique the interest of unsuspecting investors. Meme stocks typically have the following characteristics that differentiate them from conventional stocks.
Investing in meme stocks can be tricky. Many lay investors get burned by the promise of these stocks "going to the moon." Catchphrases like, "Hold on for dear life" become popular while the stock is actually declining from its peak prices. For that reason, it's always important to understand how to trade these vehicles.
Here are some useful tips for investing in meme stocks:
Before investing in any stock, or a meme stock for that matter, you should analyze the company’s financials to determine whether the stock’s price justifies its financial performance. If the price doesn’t correspond with the company’s fundamentals, it could signal a bubble that could pop at any time. Sometimes, there is significant news about the company that momentarily spikes a stock’s trading volume and price within a justifiable range.
However, with meme stocks, prices can rise abnormally -- as high as several hundred percentage points within days -- with volume showing a similar unusual trend. Analyzing the company’s financial statements and key financial ratios, for example, its price-to-earnings ratio, are completely thrown out the window during these frenzies. Nonetheless, day traders prudent investors read the company’s financial statements thoroughly to determine if the stock is fairly priced. For example, if a stock is trading at P/E multiples significantly higher than its peers, it could well be overpriced and is a sign of caution.
Meme stocks are highly volatile compared to traditional stocks, which is why implementing risk management strategies becomes even more important when trading these stocks. This will help protect your capital by taking you out of the trade in case the market moves against you while allowing you to reap potential profits.
Timing is also crucial when trading meme stocks. For example, if you buy a stock that has already soared to unprecedented levels, it might be too late as the early buyers begin dumping their holdings to cash in their profits. Once this happens, it will send the stock crashing. In such cases, a trade without stop loss could easily blow up your account.
When meme stocks experience high volatility and trading volume, you can expect large wild swings in the price, which can get your heart pumping and affect your sleep as you see your trade oscillating between profit and loss. In such a scenario, you need to have a proper trading plan in place so that you don’t have to intervene manually to close the trade. This will allow you to keep your emotions aside and let the trade close at your take profit or stop-loss points automatically. Having a properly sized trade commensurate with your risk appetite and account size will also help improve your trading psychology and keep you emotionally neutral during trades.
Before buying a meme stock, you should determine whether you want to hold it for the short term or the longer term. If you want to trade it for the short term, you need to be on top of the catalysts that drive the stock’s price and volume. This will help you trade in the direction of the trend while keeping your downside risk to a minimum. Needless to mention, risk management measures should be put in place while entering short-term trading in meme stocks.
If you want to hold a meme stock for a longer term as part of your portfolio, you need to determine what portion of your total portfolio should comprise meme stocks. Depending on your risk tolerance, you can determine the optimal percentage holding of meme stocks accordingly. Theoretically, high-risk stocks such as meme stocks can have the potential to increase your gains, but can also increase losses.
A well-diversified portfolio can greatly reduce the risks associated with holding meme stocks as the stable shares in your portfolio will absorb some of the volatility. But since the trends in meme stocks usually last for a short time, it would be sensible to either offload the shares at the earliest signs of the trend reversal or avoid holding them for the longer term.
Historically, most major moves in many meme stocks originated after recommendations, discussions, and hype on social media. So, it is essential to keep yourself updated with the discourse on various social media platforms, such as Reddit, X, YouTube, Facebook, etc.
You can join different investment-related social groups that are highly active and have a large audience to see stock recommendations and popular stories about certain stocks. This will help gauge the overall sentiment. Staying abreast of sentiment can be invaluable when you become part of the early buyers of the stock at the start of the trend. However, you should perform due diligence before buying a stock solely on the recommendations of social media.
The Short Interest Ratio denotes the percentage of a company’s shares held short in relation to its average daily traded volume. For example, a stock with a 20% Short Interest ratio means that 20% of the company’s average daily traded volume of shares has been held short. In other words, it indicates how heavily a company’s stock has been shorted.
Because of their mostly below-average fundamentals, these stocks are least desired by many investors, while some sell them short. A Short interest ratio of 30% and higher is generally considered high, and stocks with such high ratios can become a target for a short squeeze.
Suppose the price of a meme stock with a high short interest ratio starts to rise, the short sellers, who had bet against the prices rising, feel pressure as they start to lose money. To prevent losing money, they have to close their positions and buy the stock, which creates even more demand for the stock, pushing the price higher and higher. The situation continues until the short-interest ratio normalizes and the trend starts to reverse. Some of the famous short squeezes in recent history have been GameStop Corp. (GME) and AMC Entertainment Holdings Inc. (AMC) stocks.
Many different variables can affect meme stock prices. Here is a short list of what we consider the most influential factors:
Meme stocks thrive on stories, rumors, and predictions shared by users in different social media groups. Some social media sites like Reddit have been the force behind the meteoric rise of GameStop (GME) and AMC Theaters (AMC) stocks.
You never know when new meme stocks could experience a similar trend, driven by the chatter in the retail investors’ groups on social media. So, following popular social media groups, particularly on Reddit (subreddit r/wallstreetbets), could help you spot the next rising meme stock.
Many meme stocks are below-average businesses and have lackluster financial conditions. The majority of the time these are not actively traded. When the trading volume does increase, it is usually attributable to retail investors’ sentiment influenced by conversations on various social media platforms. The huge rise or decline in prices does not reflect the company’s underlying financials, but merely speculation on the part of a group of investors.
As a prospective trader of meme stocks, you should be familiar with the phenomenon of short squeezes. Short squeezes often contribute to a drastic rise in the price of heavily shorted stocks. While the initial push in the stock price might be launched or planned by a group of retail traders, the subsequent rise comes automatically as the short sellers of the highly shorted stock rush to liquidate their positions to stop their losses.
The buying of shares by short sellers creates additional demand for these shares, pulling the prices further up. As a result, more and more short sellers close their positions until the momentum loses steam and prices start declining.
Let’s have a look at the example of a meme stock named GameStop (GME) to demonstrate the price of such stocks during different market conditions and phases.
GameStop, an American brick-and-mortar video game retailer, was badly impacted during the pandemic, with many hedge funds heavily shorting its stock. However, in August 2020, a famous YouTube influencer Roaring Kitty, also known as Keith Gill, predicted that the stock price could rise from $5 to $50 due to the presence of high levels of short-interest positions in the stock by hedge funds. He explained that the hedge funds with massive short-interest positions would be trapped in a short squeeze, forcing the stock further up.
Following Kitty’s prediction, investor Ryan Cohen bought a 10% stake in GME, and after he joined the company’s board in January 2021, the stock price had doubled in just two days while it had increased eightfold since Gill’s initial prediction in August 2020.
During the same month, the short squeeze, as forecasted by Gill, indeed happened as the stock skyrocketed to $500 due to panic buying by hedge funds to cover their open short positions. Many of the hedge funds could not bear the losses and were forced to shut down.
The stock retreated gradually and settled at $10 in 2024 when Keith Gill resurfaced and posted a cryptic message on social media. The post, though not a buying or selling recommendation for any particular stock, created a buzz on social media. This resulted in a significant surge in trading volume in GME stock and hiked the price by 100% in a single day, with several subsequent jumps the following day.
The fascinating story of the GameStop (GME) reveals several important characteristics of a typical meme stock. They can rise to unthinkable highs and lows in a matter of days, just by the actions of a few individuals on social media.
The initial spike in share price attracts the interest of new traders, and after the stock goes viral on social media due to its huge price surge, the stock has completed most of its price surge. Those traders who are late into buying the stock end up panicking when the price starts to retreat, as the early buyers cash in on their profits.
Given the historical jumps in meme stock prices, many investors are drawn to investing in them to make quick money. While the potential to earn significant gains is present, meme stocks are also highly risky. You need to understand the characteristics of meme stocks, the factors that drive their prices, and implement trading strategies that work particularly well for such securities.
We recommend you follow social media to track the lesser-known but most-searched stocks and see if there are any turnaround stories behind them. You can also consider following social media investment gurus to see what underrated stocks they recommend.
Unlike conventional stocks, meme stocks are subject to price manipulation by different players due to lack of interest from large institutional investors. So, before investing in them, you need to be diligent and conduct your research. This includes forming a well-devised trading and risk management strategy, analyzing social media for clues, checking for the stock’s short-interest ratio, and ensuring that you enter the market in the early stages of the trend.
The stock usually trades normally after the social media-generated frenzy subsides, which is when you can use technical analysis tools to trade the stock like any other traditional stock. If you want to trade meme stocks by technical analysis, you need to ensure that there is no buzz about the stock on social media. You can also use an advanced simulation platform like Tradinsim, which will help you a great deal in taking your trading to the next level as it would help you clear out the noise and false signals from the market.
If you want to study the history of meme stocks, there is no better place to do this than at TradingSim. Jump in the sim with our 7-day free trial and see what you can learn about the AMC stock chart.
Tags: Day Trading
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