Jul 3, 2024
Written by:
John McDowell
Meme stocks are shares of companies that have gone viral on social media platforms as a result of investing recommendations. They are the subject of popular topics of discussion on online forums among retail investors. In these forums, investors and traders toss around investment ideas, stock price predictions, or turnaround stories of different companies.
Reddit, Facebook, and X (formerly Twitter) are the most popular social sites where investors congregate and devise their strategies. These channels allow participants to get support from like-minded individuals who provide them with an opportunity to convince other investors of their investing argument, hoping to make a stronger and lasting impact on the stock price.
In this article, we will cover several important aspects of meme stocks and also highlight how hedge funds and short squeezes influence their prices.
What makes meme stocks different from traditional, blue chip stocks, and are meme stocks and penny stocks the same? The answers to these questions will help you distinguish meme stocks from conventional stocks as well as penny stocks.
Blue chip stocks are shares of well-known companies like Google, Meta (Facebook), Amazon, and Apple, or even Ford, GE, and Boeing, that have strong business models, a history of solid earnings, stable share price, and a host of other qualities. Blue chip stocks are mostly mega capitalization stocks (market capitalization in excess of $2 trillion) and large-cap stocks (market capitalization between $10 billion and $2 trillion).
Most common stocks, on the other hand, might not be as famous as blue chip stocks but have good trading volume and promising business model, backed by years of revenue or profit growth. While there is no strict definition that defines “traditional” or “conventional" stocks, we use these terms broadly to highlight their distinguishing characteristics from meme stocks.
Generally, meme stocks have a low average daily trading volume with lackluster financials and fundamentals that make their stock prone to price manipulation. Some of the most popular ones have even gone bankrupt, like Bed Bath and Beyond. But, with concerted efforts, even a group of retail traders on social media can sway the prices. This kind of price manipulation is usually difficult, if not impossible, for blue chip stocks with a high average daily trading volume and stable financials.
Lastly, penny stocks are called such because of their low stock prices, typically below $5 per share. Most penny stocks trade over the counter instead of on organized exchanges. While meme stocks mostly trade on exchanges like they NYSE or NASDAQ. Similar to meme stocks, prices of penny stocks are prone to manipulation at the hands of a few large players who act in unison.
When a meme stock experiences a price hike along with heightened volatility and trading volume, it could be a sign of an organized social media campaign launched collectively by groups of retail investors. Even hedge funds and prop-firm traders could be behind the move -- or at the very least be taking advantage of it.
What ensues with the stock price can be analyzed and divided into different phases. Here are the important phases that a meme stock typically undergoes following a social media-backed onslaught:
The initial phase in the stock price rally is underscored by a slight rise in the price, which can be confirmed by a simultaneous spike in trading volume. Stocks with high short interest are ideal candidates for encountering a short squeeze. Investors active on social media, motivated by the recommendations from social media influencers or stock gurus, start buying the stock in droves. This resultant surge in demand for the stock increases its price, which draws the attention of the undecided investors as well.
After the initial stock price surge, new investors also join the trend, pushing the stock higher. Investors or hedge funds who had shorted the stock heavily start feeling pressure due to a sudden rise in stock price and close some of their positions (buying back the stock). This shoves the stock price further up as demand for shares rise in the market. The buying pressure creates a chain reaction and forces investors with short positions to settle their trades, propelling the stock, once again, to unprecedented levels. Some fresh buyers further contribute to the price hike.
During this phase, the price has risen so much that the news of the price hike spreads to even those investors who missed out on the buying opportunity in the early buying and the middle phases. The Fear of Missing Out (FOMO) kicks in, and the new investors also join the bandwagon in an attempt to get the part of the explosive ride the stock is going through. But the price is nearing its peak during this phase as the short interest in the stock is about to end, with no further room for further price increase. In other words, this phase marks the last brief leg before the end of the price rally.
During this phase, the early buyers start to liquidate their positions and book their profits. The resultant selling pressure pulls the price downward, prompting other investors to sell their holdings and exit the market. A cascading effect occurs that runs through the market, effectively sending the stock price crashing. Short-term day traders seize the climactic action and initiate huge short positions. The middle phase investors, fearing of their positions turning negative, also exit their positions, leaving the FOMO investors in losses. Finally, when the price is in a free fall, the FOMO investors or late joiners also take the losses and have to exit the market.
Hedge funds and short squeezes play important roles in driving meme stock prices. Let’s understand the interplay between meme stocks, hedge funds, and short squeezes.
If a stock has a high short interest ratio, it can become more susceptible to a short squeeze by investors. A high short interest ratio indicates that a significant percentage of free-float shares of a stock has been sold short by institutional investors such as hedge funds, banks, pension funds, or by individual investors. This means that a vast majority of investors predict the stock price to decline in the near future and have made short bets on the stock price.
Seeing such a high number of short sellers, individual investors on social media, along with discerning prop firm traders, aggregate buying pressure in order to carry out a short squeeze by buying the stock simultaneously and collectively driving the price up. As the price rises, heavily shorted institutional investors like hedge funds rush to close some of their short positions by buying the stock to limit their losses. But instead of making things better, the buying from hedge funds fuels demand for the shares, which further pushes the price up.
Hedge funds get trapped in a short squeeze as the rising prices lures further investors into buying the stock, which keeps pushing the price higher. Hedge funds and other players who have sold the shares short have no other option but to buy the shares to get out of their positions as the losses become unbearable, which has a ripple effect on the prices. The buying from hedge funds and new investors continue side by side until the short interest is eliminated and the price has climaxed.
The price then starts declining as early buyers book their profits.
Meme stocks came to prominence in early 2021 when GameStop Corp (GME) and AMC Entertainment (AMC) were subject to short squeezes by social media retail investors. The turn of events left big firms at wall street flabbergasted as no one ever thought of retail traders congregating and leveraging the power of social media against big hedge funds. Several of the big hedge funds faced catastrophic losses during the GameStop and AMC Entertainment short squeezes.
But the question is can such events be repeated in the future?
On 13th May 2024, both GameStop (GME) and AMC Entertainment (AMC) meme stocks again jumped by almost 75% in a single day, with the gains extending further to 158% for GameStop and 132% for AMC Entertainment before the opening bells on the next day. Both the companies have been avoiding bankruptcy, thanks to the occasional coordinated short squeezes by retail investors, as the companies have been able to raise additional money during these short bouts of squeezes.
The stock rise was a result of a tweet from Keith Gill (also known as Roaring Kitty) a night earlier. This goes on to show that social media investing has materialized into a new phenomenon that we might see quite frequently.
Amid thousands of stocks, how can you identify whether or not a stock is a meme stock? These stocks have unique characteristics by which you can easily distinguish a meme stock from other types of stocks. Let's have a look at some of the attributes:
Meme stocks, as their name suggests, are popular on social media. They usually go viral on social media due to a number of reasons, including buying recommendation from social media celebrities, purported turnaround stories, execution of short squeeze strategy, floating of investment idea, or highlighting undervalued stocks. In other words, there is quite a buzz around these stocks on social media. So much so, that it catches the attention of a large number of retail investors and hedge funds, who can make a formidable force and can drive stock prices when acting collectively.
So, if you see a stock consistently featured in discussions on social media, it could be considered a meme stock and might be subject to price rally in the future if other conditions, such as presence of high short interest, execution of short squeeze, and traders acting in unison, are met.
High Short Interest
When there is a high short interest in a stock, and it is being highly circulated online, it is a major sign that the stock could be experiencing a short squeeze in the near future. The short squeeze strategy pushes the stock price up automatically as short sellers rush to close their positions, after a brief initial push by a group of social media traders.
If you see a stock being excessively discussed on social forums, and the stock is trading at unrealistically high levels compared to its peers, it could mean that the stock price has been manipulated due to social media influence. One of the prominent characteristics of meme stocks is that its price is detached from its fundamentals and financials, and mostly when it is under the influence of social media hype. The stock trades at unreasonably high price to earnings multiples. Such a high price isn't justifiable, neither through fundamental nor technical analysis, as it is largely being driven by social media hype.
Ordinarily, meme stocks have a thin average daily trading volume, meaning they lack interest from large institutional buyers due to their weak financials and fundamentals. However, some hedge funds often make short bets on those stocks to generate quick profits for their clients. If you see a thinly traded stock’s volume experience a sudden hike in its trading volume, you should confirm if the jump in volume is the result of social media discourse or a genuine hike resulting from a change in company’s fundamentals.
Whether you are new or an experienced investor, understanding how meme stocks work and the factors that influence their prices will help you improve your stock picking and portfolio building. With their occasional yet explosive growth, meme stocks can be a great addition to your portfolio provided that you combine it with risk management principles. The high profit potential also comes with assuming a higher risk of losing your money. If you want to include it in your portfolio, make sure that the total allocation to meme stocks constitute only a smaller percentage of your total holdings. Also, the assets you hold in your portfolio should be diversified according to your risk profile and objectives.
If you have a short-term investment horizon, like day trading or swing trading, you can devise a short-term trading strategy. This might include analyzing investing groups for high short interest stocks, undervalued stocks, buying recommendations, and other interesting statistics or important news. However, before taking a jump, you need to ensure that you join the trend in the early or middle phase of the short squeeze or market rally, and are not getting caught in the FOMO or final phase.
Also, determine your profit-taking and stop-loss points before entering a trade to eliminate the in-trade stress and emotions. Don’t risk more than 2% of your account equity at risk on a single trade. This will help you keep in the market for the longer run even if some of your trades end up in the negative.
If you are a technical trader and want to trade meme stocks on technicals, it is recommended that you do so when there is no short squeeze or social media influence on the stock. Again, you can confirm this by analyzing social media and checking for any abnormality or deviation in the stock’s trading volume from the normal daily average trading volume. Better yet, advanced stock simulation platform like Tradingsim can help you a great deal in trading as you can use different tools trade historical meme stock runs. This helps you to filter out the noise and apply your trading strategies effectively, without risking real money.
Tags: meme stocks
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