What Is a Meme Stock?
Meme stocks are company shares that have gone viral due to popularity among retail investors on social-media platforms.
In a traditional buy-and-hold strategy, investors seek stocks whose shares appear undervalued relative to the company’s fundamental worth or growth potential. In contrast, prices of meme stocks are closely tied to sentiment and chatter among day traders on the Internet, rather than the value of the underlying business.
Here’s a closer look at meme stocks and how to navigate this market phenomenon.
Background on Meme Stocks
In the past, when it came to institutional investors vs. retail ones, the former were thought to hold clout in markets, while the latter was considered a side show and even referred to as “dumb money.” After all, the top 10 largest institutional investors made up 43% of the average public company’s ownership, according to October 2019 data from the Organisation for Economic Cooperation and Development.
But in 2021, small investors showed they could be a force to be reckoned with, coordinating trades on Internet platforms like Reddit, Twitter, YouTube or Discord to fuel big price swings. These investors also helped drive moves in different types of cryptocurrencies as well as SPACs, or special purpose acquisition companies.
In January 2021, Investors on the Reddit forum “r/wallstreetbets” banded together and triggered a short squeeze in GameStop Corp., a popular short among hedge funds. When an investor or trader is shorting a stock, it means they’re wagering that the price of the shares will fall. A short squeeze refers to rapid price gains in a stock, as traders exit their bearish positions en masse.
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Retail investors succeeded in triggering a short squeeze and losses for hedge funds, who have now turned to trying to monitor social-media forums in order to spot the next meme stock.
However, controversy ensued when some brokerage firms halted trading in some meme stocks, citing an inability to post collateral at clearinghouses. Such moves led to angry retail investors and day traders and congressional hearings that looked into brokerage practices such as payment for order flow.
Pros and Cons of Trading Meme Stocks
Benefits of Trading Meme Stocks
1. Rise of Retail Trader: Retail investors have shown they need to be taken more seriously by the rest of the market. Barron’s reported that 58% of day traders in a survey said they plan on trading even more in the future, a sign that meme stocks and retail participation in stocks is not just a Covid trend.
2. Younger Investors: Given the hyper-online ways in which meme stocks come about, younger investors have learned more about investing and trading through these social-media fads. Still, it’s unclear whether meme stocks will help engender healthy long-term financial planning habits for beginner investors in their 20s.
Risks of Trading Meme Stocks
1. Lack of Fundamentals: Meme stocks tend to go viral not because of the performance or potential of the underlying business, but because of the sometimes irrational enthusiasm of retail investors and day traders. That puts meme-stock investors at greater risk of downward share performance, if the fundamentals of the business disappoint when the economy or markets dip.
2. High Volatility: Studies have shown that passive, diversified investments tend to outperform active trading over the long term. The volatility of meme stocks means that investors are at greater risk of locking in losses or seeing their portfolios underperform in the near term. Take for instance, when trading was halted on GameStop, investors potentially couldn’t execute sell orders.
3. Potential Stock Dilution: In some cases, meme-stock companies have tried to take advantage of higher valuations by issuing new shares. In such examples, it’s important that investors understand stock dilution, which occurs when the number of outstanding shares increases and every shareholder ends up owning a less significant piece.
How to Trade Meme Stocks
Single-name stocks are also not the only ways investors can get exposure to meme stocks. Options trading in meme stocks tend to be quite liquid, often allowing investors to buy and sell calls and puts easily.
If an investor doesn’t want to research or follow specific meme stocks, another way to get exposure to the phenomenon is by buying an ETF that holds companies popular on brokerage platforms.
In addition, here are some precautions that investors can take when trading meme stocks:
1. Diversify Your Portfolio: Rather than just holding meme stocks in their portfolios, investors may benefit from also getting exposure to more broad-based ETFs, blue-chip stocks, or dividend-paying companies. Such stocks tend to post more muted price moves, which may help offset the volatility of meme stocks.
2. Set Stop-Loss Orders: Investors can pre-set orders so that a meme stock automatically gets sold if it hits a certain price. A stop-loss order can be used to lock-in profits, so if the shares rise, or to limit losses, if the stock’s price falls.
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The proliferation of zero-commission brokerage accounts, and stay-at-home orders due to Covid-19, led to an individual-investor surge in 2020 and 2021. According to Bloomberg, retail-investor participation in the US stock market jumped from 15% in 2019 to 23% in February 2021.
Sometimes such traders target companies with high short interest to turn into meme stocks. Meme stocks tend to be company shares as opposed to exchange-traded funds (ETFs). Certain meme stocks like GameStop and AMC captured news headlines by posting colossal gains rapidly, but once the trading frenzy subsided, many meme stocks also plummeted.
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