Jul 9, 2024
Written by:
John McDowell
We've talked a lot about meme stocks at TradingSim, mainly because they are so popular among traders. If you're unfamiliar with what they are, they're basically shares of not-so-great companies that have gone viral on social media platforms, garnering significant interest from retail traders.
Influenced by social media, when individual traders buy the stock simultaneously in droves, the price and trading volume experience a sudden hike, attracting more and more buyers. The price rise is purely a result of an abrupt buying frenzy from a group of retail traders or other institutional short-term traders and not because of the underlying improvement in the company’s fundamentals.
GameStop Corporation (GME) and AMC Entertainment (AMC) are two classic examples of meme stocks as individual traders collectively executed a short squeeze strategy on these stocks and pumped their prices to unimaginable levels, with GME gaining more than 2,500%, while AMC around 1,000% in a single month. Traders who had bought the stock during early phases and exited near the peak booked formidable gains, while those who bought it near the peak had to suffer losses as the price subsequently dropped considerably.
The GameStop (GME) and AMC Entertainment (AMC) episodes have important lessons for those interested in understanding the motivations and behaviors of individual traders involved.
In this article, we will explore the psychological factors that drive meme stock trading and analyze the behaviors and motivations of a typical meme stock trader.
Social media platforms such as Reddit and X (formerly Twitter) play a key role in driving meme stocks. Undecided traders seeking investing cues join various social platforms, groups, and forums. In other words, meme stock psychology is characterized by a type of trader who needs social proof for their investment decisions, which they easily get from social media channels.
For example, the popularity of a stock on reddit or X and the endorsements it gets from various social influencers like RoaringKitty reflect its social proof, making it an ideal meme stock candidate. Meme stocks have an emotional excitement and appeal for traders who like to jump on the bandwagon and are influenced by popular opinions and endorsements.
Meme stock traders have a high appetite for risk-taking, which is a prerequisite for earning the potential high rewards these stocks have to offer. This means that they can tolerate wild price fluctuations without any emotional distress because they consider trading akin to gambling. They make most of their decisions impulsively based on online social trends.
Their thinking exhibits cognitive biases, meaning they either use social channels to confirm their existing beliefs about a stock or reveal herd behavior by simply joining the group. The cognitive biases are a result of not conducting their own research before investing in a stock, but rather relying on the information on social forums. These thinking biases often result in poor investing decisions as these are based on one’s emotions and preconceived notions instead of data.
Meme stock traders usually have short-term trading strategies as they don’t believe in investing for the longer term. This is because long-term investing involves carrying out fundamental analysis to find undervalued stocks, and the gains are realized after holding the stock for a longer duration, usually more than six months. In contrast, meme stock traders, through their concerted efforts, execute pump-and-dump strategies to realize quick gains and exit the market.
So what motivates individual traders to invest in meme stocks?
First, the meme stock investors get a sense of belonging and accompaniment by a group of investors who have shared interests. This serves as a motivation to support each other with enthusiasm. The trading strategy they adopt is collective and is derived from the group wisdom, which also gives them a sense of security as well.
Another motivating force for meme investors is the opportunity to make huge, rapid gains after they hear and read testimonials and rags-to-riches stories of different traders. Some of them draw on the thrill and entertainment from trading meme stocks as the dopamine rush from seeing your trade sway from profits to losses.
They just can’t keep themselves away from trading and participating in the adrenaline rush.
Some traders, with anti-establishment sentiments, trade meme stocks and become a part of the group of retail traders in order to execute a short squeeze on big financial institutions. They do so to end the monopoly of the large institutional investors of Wall Street and want the individual investors to balance or shift the center of power from Wall Street to ordinary investors. They believe that they can democratize finance by using the power of social media.
Various social dynamics also come into play that shape the motivations and behaviors of meme stock traders.
For example, the role of Reddit’s WallStreetBets and other similar online communities helps traders form beliefs about certain stocks through the use of combined intelligence and information sharing. The beliefs are further strengthened due to echo chambers and groupthink as the prospective traders can’t think out of the box but just follow what is being perpetuated on the forums.
Features such as likes, comments, and shares available on different platforms also give weight to the acceptability of the idea by others. For example, a post or idea with too many likes, comments, or shares may point to the approval and endorsements from other group members, which can impact the beliefs neutral traders and make them believe in the idea.
Because of the large number of like-minded individuals on the platforms, the room for having diverging opinions is limited, if not non-existent. This puts pressure on independent-thinking individuals to shun their beliefs and conform to the group’s viewpoint. When the traders become well-integrated into the group, it gives them social validation – a form of approval from the group and a feeling of belonging to the community.
Herd behavior is the tendency to follow the majority without thinking independently. In investing terminology, this means to follow the investment advisory or recommendations of a group without conducting one’s own research. The herd mentality may arise because of the fear of losing if one stays against the crowd. By being a part of the group, there is a sense of security because of the notion that the group’s collective wisdom won’t be wrong.
Herd behavior is reflected in the fear of missing out (FOMO). This usually happens when the stock or an asset moves higher, with more and more investors joining the trend due to fear of missing out on the potential gains. The decision of new traders to join the trend is impulsive and driven by greed as they see their peers making huge gains.
The phenomenon of herd mentality was evident during the short squeezes of GME and AMC stocks in early 2021 when the initial price spike resulted in new buyers joining in, which pulled the prices further up. Some late FOMO joiners, out of fear of losing out on the profit-making opportunity, bought the stock at or near the peak and ended up on the losing side. Irrational thinking, greed, and urgency to realize gains all lead to FOMO investing, which can sometimes backfire and put an investor in a losing position.
Retail TradersBecause retail traders are the driving force behind most meme stocks, we need to understand what enables them to collectively steer the prices and execute different strategies like short squeezes.
Retail traders today have access to numerous commission-free trading platforms such as Robinhood and WeBull. They can access the platforms from their smartphones and trade from anywhere. Further, the platforms have all the advanced features like price charts, news, order types, and technical indicators that allow them to execute any kind of strategy.
Some trading platforms also allow social trading, which enables traders to copy the trades of top traders. The feature can be extremely useful for meme stock traders who, instead of conducting their own research, rely on information on digital platforms or from social media influencers.
During the short squeezes of GME Corporation and AMC Entertainment stocks, several large hedge funds suffered losses at the hands of retail investors. This was due to the inclusivity of trading as individual traders have access to different trading terminals. Further, social media has reduced, if not eliminated, the disparity between the individual and institutional investors in terms of resources available to them.
The advent of online trading has played an instrumental role in shaping traders’ psychology. Due to the advent of online trading, traders can trade anonymously using their smartphones or can take as much risk as they deem fit, without being judged by others for their investing decisions. Neither do traders have to interact with brokers physically or over the telephone, nor do they have to be on the trading floors for trading. The privacy that they get from online trading enables traders to be their true selves, take on higher risks, and be more aggressive than they might otherwise be.
While online trading allows individual traders to trade at any time, even on the go, this technology can sometimes be counterproductive if not used responsibly.
For example, a trader might open a trade impulsively without analyzing the market conditions or devising a trading strategy just because they have access to the market 24/7 on their phone. Further, the fact that they could see the result of their trade instantly on their phone screens also adds to the temptation of trading impulsively. In other words, the ease of trading by just tapping your phone screen is a bane for certain types of traders who can’t control their emotions and trade haphazardly for fun and excitement.
Behavioral finance is an area of study that proposes various theories explaining the impact of psychology on investors’ behavior. The popular theories include prospect theory, overconfidence bias, mental accounting, among others.
The prospect theory explains that investors are more sensitive to losses than gains; they feel the pain of losing money more intensely than the joy of earning a similar amount of money. This means that they would avoid taking the risk if there is a potential of losing money on the investment.
In the context of trading or investing, overconfidence bias refers to the mistaken belief of traders that they have the skills and knowledge that are required to succeed in trading. They tend to overestimate their strengths while ignoring their weaknesses, which often results in their downfall. Traders with overconfidence bias often trade too frequently, underestimate risk in trades, and trade in unfamiliar assets.
The mental accounting theory postulates that investors mentally divide the total cash savings available to them into various categories, such as leisure, spending, emergency funds, trading, etc. When investors allocate funds to trading activities, they effectively earmark them for risk-taking activities and subconsciously are willing to lose them in case their investments don’t turn their way. This mental allocation of “risk money” often results in careless investing, which can potentially wipe out their accounts.
By understanding these common psychological factors, traders can correct their irrational behaviors and ultimately improve their trading performance.
The rise of meme stocks on the financial landscape has led to the rise of a new breed of investors – meme stock traders. Like conventional traders, their trading psychology can also be understood by their behaviors, motivations, and social dynamics.
To recap, meme stock traders typically exhibit the following trading behaviors:
They indulge in high-risk trades to earn large, quick profits. They like to gamble by investing in meme stocks that are typically associated with high volatility with deteriorated fundamentals. They trade impulsively without undertaking due diligence. Even a stock recommendation on social media can be a sufficient trigger for them to trade the stock. Their lust for generating quick profits instigates their FOMO “fear of missing out” behavior, which compels them to buy skyrocketing stocks. The FOMO behavior was evident in the short-squeeze episodes of the GME and AMC stocks.
Meme stock traders draw their motivation from each other as a group. They have a herd mentality and seek safety by following the herd. They believe that by following the group, their investment will be safe because the collective wisdom of the group can’t be wrong. It was the herd mentality of retail investors on social media that was the driving force behind the dramatic price rise and short squeeze of AMC and GME stocks.
Meme stock trading has attracted the interest of many new traders, and even those on Wall Street are wary of what individual traders can do by leveraging the power of social media. There have been numerous intermittent episodes of short squeezes and sudden price surges in meme stocks since January 2021. And with the growing popularity of social investing and social media platforms, we can safely assume that meme stocks are going to stay relevant going forward.
So, if you are considering trading meme stocks, you must understand the psychology of meme stock traders and recognize the typical cognitive biases, behaviors, and motivations exhibited by a typical meme stock trader. This will help you avoid the pitfalls and common mistakes meme stock traders make and make you a better and more prudent trader.
Here at TradingSim, we offer tools to combat the FOMO and psychological pitfalls of uneducated traders. By spending time in our 24/7 simulator, you can track the price history of meme stocks like AMC and GME to study their movements and how you might trade them in the future. Give our free trial a try, today.
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Economic Analysis
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