A “meme stock” is a stock that receives interest from investors after gaining popularity in Internet forums and on blogs, often due to nostalgia associated with a brand or a desire to bring a struggling company back to life. Because a meme stock’s popularity is often based on sentiment instead of a company’s actual performance, these assets are extremely volatile and not recommended as part of a long-term investment strategy.
In a typical market, the value of a stock rises or falls based on a company’s success. The value of meme stocks, however, rises as more investors rush to buy shares. This can temporarily inflate the value of a stock, but almost inevitably the market regulates and the stock falls to its original value.
Famous meme stocks
Recognize any of these names? Many of the most recent meme stocks are iconic brands whose star has faded in recent years. Companies such as AMC Holdings (AMC), Bed Bath & Beyond (BBY), and Express (EXPR) have all become internet-famous as meme stocks.
GameStop is widely recognized as the first meme stock, and made headlines in early 2021 when the company’s share value peaked at $483 after closing at just over $13 a few months before.
Why? Blame the internet. How? It comes down to a few investment fundamentals: Short selling and short squeezes.
What does it mean to short a stock?
You may have heard the mantra that the goal of investing is to “buy low, sell high.” This is called taking a long position. But when shorting a stock, the goal is to sell the shares at a high price, then buy them back once they’ve dropped in value, pocketing the difference. Instead of betting that a stock’s price will go up, you’re betting that it will go down – you’re taking a short position.
Investors who short stocks start by identifying companies they believe are going to drop in value. They then “borrow” shares from their brokerage of this company and sell the shares at what they hope is a high price. Eventually the borrowed shares will need to be returned to the brokerage, so the investor waits until the value drops, purchases the shares back at a lower value, and then returns them to the brokerage – profiting from any price declines.
Obviously the process of borrowing stocks from a broker is easier said than done. It requires what is known as a margin account, and is more likely to be performed by a licensed broker working for an institution than the average day trader.
While shorting stocks is a common investment practice, it also can be one of the most risky. When taking a long position on a stock, you only risk losing the initial money spent on the shares (for example, if you buy a share of a company for $25.00, the most you can ever lose is $25.00). But if you take a short position on a stock and it unexpectedly rises in value, there is no cap to how high the price may rise, so your potential loss is technically unlimited. You’ll be on the hook for the difference in order to purchase back the share and return it to the brokerage you borrowed it from.
How shorting a stock works
Let’s say that you grew up visiting Rental Videos Inc. (RVI) every Friday night. With the advent of streaming technology, the company has been struggling in recent years.
Stock in RVI is currently trading for $4 a share, but you expect that to go down. You decide to “borrow” 50 shares of RVI from your stock broker, which you then sell for $200. Remember, because these shares that you just sold don’t actually belong to you, you will have to give them back at some point.
The next day, shares for RVI drop to $2 per share. You buy the shares back for $100, keep the extra $100 in profit, and return the stocks to your broker.
You’ve just successfully shorted a stock.
What happens during a “short squeeze” in the market?
A short squeeze happens when a stock’s value rises unexpectedly, causing investors in the short position to buy back shares at a loss. It can be a volatile cycle – the more investors buying back shares, the higher the stock prices rise; the higher the prices rise, the more those in a short position hurry to buy back shares.
Let’s go back to the previous example where you’ve again taken a short position on RVI stock, selling 50 shares at $4 each expecting the price to fall. The next day RVI unexpectedly announces a new streaming service, and investors rush to buy shares. The value of RVI stock is now $7…then $10. You want to cut the loss before the price rises even further. In the end, you’re forced to buy back shares for $500 (a $300) loss before the stock value rises too high and you’re unable to buy them back. RVI just experienced a short squeeze. While the streaming announcement would likely have boosted the company’s stock value, the rush of investors in short positions to purchase back stock pushed the price even higher.
The first meme stock: GameStop
So what does this have to do with GameStop?
Using the same example above, let’s again pretend you’ve taken a short-position on RVI shares. This time, instead of the announcement of an exciting new service, members of an internet forum – many nostalgic for the days of picking a DVD off the shelf of an RVI store – have decided en masse to purchase RVI stock. Nothing has changed about the company, but suddenly the value of the stock is rising. You and several others are hurrying to buy back stock before the price rises, creating a short squeeze.
This is exactly what happened during the short squeeze of the first meme stock: GameStop. Below is a summary of a timeline of the event, as recapped by ABC News.
How GameStop unfolded
So much had happened in 2020 – an unforgettable year in its own right – that few could have predicted one of the most historic events in Wall Street was about to unfold. Well, unless you were following a Reddit forum called WallStreetBets.
After a dismal earnings report in December of 2020, GameStop stock was trading for $13.66 per share. But the conversation on WallStreetBets was that GameStop shares were undervalued. Their reasoning? Many investors had overlooked that the same bleak earnings report also noted a 257% year-over-year increase in e-commerce. In another promising move, the company had recently added several executives from e-commerce giant Chewy to their board.
Prices began to tick up, closing at $31.40 per share on January 13, 2021. By January 25, shares were trading for $96.73. The next day, billionaire Elon Musk tweeted a link to the WallStreetBets Reddit forum and on January 26, the value of GameStop shares closed at $354.83.
A classic Wall Street Drama begins to unfold: The popular trading app Robinhood temporarily suspends trades of GameStop stock because, as they claimed at the time, they could no longer afford the clearinghouse deposits. The SEC eventually begins a review of the situation to see if they needed to take action to protect investors. Least surprising of all, a movie deal is green lighted. On January 28, GameStop shares peak at $483 per share – and then finally drop to $112.25 by market close.
The ups and downs continue (and in many ways as of September 2022, are still going on), and by February 4 following a speech by Treasury Secretary Janet Yellen, GameStop shares fall to $53.33 per share.
The risks associated with meme stocks
Watching the rise and fall of meme stock is both interesting and FOMO-inducing. But should you be scrolling Reddit, looking for the next nostalgic brand about to make headlines?
Financial advisor J.J. Lester, CFP®, calls meme stocks a “gamble” and says, as with any investment, you should never spend money you aren’t willing or able to lose. While on the surface meme stocks seem like a quick way to make money, they are extremely volatile.
“It’s an instance of people buying stocks based off an idea, instead of actual business strategy or profits, which is very risky,” Lester says.
Looking at the GameStop example, someone who had purchased shares for $96.73 in January who didn’t sell at the exactly the right time had already lost money by early February when stocks fell to $53.33 per share.
“By the time a meme stock is in the news, most of the big gains have likely happened and the opportunity for profit is gone,” Lester says. “While the rise and fall of GameStop was certainly an interesting story to follow, ultimately ‘meme stocks’ are extremely volatile and not something recommended for the average investor.”
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