What are meme stocks and how do they work?

Besides the standard and known stock trading, recent years have also given rise to a new type of stock trading; meme stocks. The world first saw meme stock emergence on the subreddit (sub-community of Reddit) thread called WallStreetBets, a place where participants discuss stock and options trading. From then on, it slowly gained popularity among investors. 

For those unfamiliar with the term subreddit, it is a forum in the online news aggregation platform known as Reddit. Reddit is an online community and forum where people discuss, share news and trade opinions on a particular topic. And the subreddit is a type of forum dedicated to one specific topic. 

In this case, the WallStreetBets subreddit, is a forum dedicated to discussing stocks, tradings and investments.

Though the hype for meme stocks died down slightly around the end of 2021, it seems they are slowly regaining their popularity this year. 

Though its first emergence was on a subreddit, the hype started around December 2020 to January 2021, when a well-known YouTube personality, who is knowledgeable about stock trading made certain comments and predictions. 

What is a meme stock?

Meme stocks are shares of a company that has gained a cult-like following on social media and the Internet.

What happens is that company’s stock prices will steadily increase as online communities (Reddit, Twitter, etc.) hype it by building and creating narratives around it on social media platforms.

And it all started with a well-known American electronics company,

 Gamestop. Their stock at the time rose by 100 times over the course of several months due to members of its meme community crafting a spectacular short squeeze.

Understanding the meme stock

A meme is an idea or an element of pop culture that spreads and is used widely across all media platforms; television shows, the Internet, social media, and messaging apps. It is usually in the form of sarcastic and humorous videos or images which are then spread and shared with other users and viewers of the online communities.

Thanks to the multiplicative and rapid effect of sharing a meme media, it can quickly go viral. Hence, the companies, brands or individuals related to the meme see an increase in stock value when an online community associated with them takes actions such as hyping and building narratives.

The first meme stock: Gamestop

Gamestop is regarded as the first meme stock. In August 2020, a YouTube persona named Roaring Kitty posted a video, which later went viral, laying the case for why Gamestop shares could soar from 5$ to 50$. 

He explained in the video that the stock had among the highest short interest in the market, largely with short positions held by hedge funds and these funds would need to cover their positions in the event of a massive short squeeze, driving the stock higher.

The predictions made by Roaring Kitty in his YouTube came to pass in early 2021.

In January 2021, when a large group of Redditors decided to buy the stock (a frenzy of panic buying), the action caused the value to increase from 18$ to $380. In other words, the short squeeze suggested by Roaring Kitty happened. As a result, a handful of hedge funds became the main victims of the short squeeze, and some were forced to shut down due to heavy losses.

The meme stock event was connoted as taking from the rich Wall Street elites and rewarding the small retail investor. Akin to Robin Hood taking from the rich and giving the riches to the poor. 

What is a short squeeze?

A short squeeze is an unusual condition that triggers rapidly rising prices in a stock or other tradable security. This condition only triggers when there are significant amounts of short sellers for tradable security, in other words, a huge amount of investors are betting on its price falling.

How does a short squeeze work?

Short sellers borrow shares of an asset that they believe will drop in price in order to buy them after they fall. In short, short sellers will need to predict the outcome. If they are right, they return the shares and pocket the difference between the price when they initiated the short and the price when they buy the shares back to close out the short position.

However, if their prediction of the outcome is wrong, they will be forced to buy at a higher price and pay the difference between the price they set and its sale price.

Examples of other meme stocks

After Gamestop, there were several other companies that also got into meme stocks and saw success, namely AMC Entertainment Holdings Inc. (AMC). 

Alas, much like traditional stock trading, a meme stock has high volatility, if not more since it depends on the public perception and hype built around it. 

Hence, not all meme stocks managed to see a good and happy ending, such as Bath, Body & Beyond; Redditors bet that the stock price would go up because it was said that the Gamestop chairman and an activist investor, Ryan Cohen, acquired 10% of the company. But soon after, Cohen sold his stake and the company announced that it will be selling an undisclosed amount of shares and had plans for layoffs, the stock took a plunge.

How do social media and the Internet influence meme stocks?

Conversations, discussions, and sharing create a buzz around a stock meme known as the hype that influences people to not only discuss and converse about it but also take the same action (s) as others. The situation can be described as a cult-like following, a situation where a group of people shows great dedication to an idea, a movement, or a work.

Meme stocks vs traditional stocks: what are the differences?

There are several differences between meme stocks and traditional stocks that you should be aware of before getting into them. As it will provide you with good insight.

Meme Stocks

Despite sounding different, meme stocks are still stocks. This means if a person buys one, they will essentially become a part of the company. The only difference is the approach; where meme stocks’ price and value depend on the hype and narratives built around them. In other words, it depends on the public perception very strongly, making it very volatile. 

Traditional Stocks

As for traditional stocks, their values are based on the market, company outlook, the wider market and past performance.

So it doesn’t depend much on public perception, which means it won’t take a massive hit from a changed public perception.

Meme stocks cycle

There are four cycles in meme stocks that you need to be aware of. This would help you gauge where the meme stock cycle is currently at and ensure you jump into it at the cycle you want.

Early adopter

This is the phase where a large handful of investors will take a look at a stock and believe it is undervalued. Once the stock is confirmed as undervalued, they will start buying the said stock in large quantities. This bulk purchase will cause the stock price to slowly but steadily increase over time. 

Middle phase

The middle phase is the stage where investors that have been observing will notice the increase in volume. More investors will start buying the stock, causing the stock price to skyrocket. You can still enter at this stage but understand the risks. 

Late phase

At this stage, word has spread across all media about the stock price skyrocketing. Because of this a lot of investors will experience fear of missing out and start buying the stock. The stock value at this point really starts to take off. 

Profit-taking phase

The last phase where sometimes after a few days of buying peaks, the early adopters will start cashing out and will cause a chain reaction as other investors will start to worry about losing money because typically this is the phase the stock price will start to go down. 

Meme stocks are prone to risks and rewards too

Meme stocks are just like any other stocks, they carry a certain level of risk and are not immune to it. And since meme stocks’ value and price are influenced heavily by public perception compared to traditional stocks, they carry their own level of risks and rewards.

Remember that the risks and rewards will generally affect individual investors in the general public. What this means is that, unlike the stock’s performance that can alter the value of massive hedge funds’ short position, the risks and rewards affect you.

The risk of meme stocks

Meme stocks are highly volatile because not only can there be a large number of people buying into a stock, but there can also be a large number of people exiting their position in the short term. 

In addition to that, meme stock is often influenced by a particular influencer or a community to build hype and spearhead the stock movements.

The reward of meme stocks

The reward offered by meme stocks is the big gains. When a large number of investors are able to band together, the upswing will be dramatic. Besides the big gains, meme stock is also a sort of symbolisation for market democratisation, something that everyday investors have been working towards.

How to trade meme stocks?

If you are interested in trading meme stocks, several steps need to be followed to ensure you can lower as many risks as possible.

Open an account

Of course, before you can trade meme stocks you will need to register and open a stock trading account first. 

Choose the product

After that, you will need to choose between CFD and spread betting. 

Use risk management tools

By using risk management tools, you will have access to stop-loss orders which can help to control your losses by closing you out from a trade that seems to go against you. But they may also be triggered by short-term price movements, which can close you out from potential and profitable trade if the price were to change again. 

Learn about its volatility first

Besides using risk management tools to help you control losses, it is also important to learn how to trade on volatility since meme stocks tend to be very volatile. 

Analyse the market and leverage on social media

When trading meme stocks, social media is your best friend. Meme stocks movements mostly start with a social media community or influencer. So it is always good to keep your ear close to what’s the currently trending theme on social media. This will help you to analyse the meme stocks market. 

The ultimate question is..should you do meme stock trading?

The short answer is; depends. 

The long answer; while some meme stocks have experienced and are able to achieve short-term price rallies, thanks to the power of memes and their online communities, it is likely that it won’t suffice for long-term price appreciation. In addition to that, meme stocks are considered speculative, so it is quite risky and not advisable to invest money in them.

On the other hand, it does provide you with an opportunity to make quick profits. But whatever it is you will decide, remember this; there are pros and cons to following trends, so it is always better to keep a balanced portfolio as it is a fruitful hedge against sentiment based-trade.

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Disclaimer: This article is intended for informational purposes only. All details are accurate at the time of publishing. Instarem has no affiliation or relationship with products or vendors mentioned.