What Are Meme Stocks?

July 20, 2022

Meme stocks refer to the shares of a company that gained popularity among retail investors through social media. The popularity of these stocks is generally caused by sharing internet memes on social platforms such as Reddit’s r/wallstreetbets

Understanding Meme Stocks 

The meme stock phenomenon revealed a significant shift in the landscape of stock trading, especially day trading. Large broker-dealers felt the majority of the pain of meme stocks blowing up, which illustrated for the first time how a large number of small-time investors can coordinate with each other to manipulate the marketplace.

As platforms like Robinhood have made day trading more accessible, meme stocks saw outsized support from retail traders rallying together to buy up shares. Meme stock mania led to some major wins for retail investors and losses for institutional short sellers.

How were these stocks identified? The basic premise behind most meme stocks is that hedge funds and other institutional traders are bearish on a company, betting large amounts of money against this stock. When institutions are bearish on a company, they short the stock to try to profit from its share price decreasing. When the stock dips, meme buyers swoop in to buy up shares which, in turn, drives up the price at the expense of the hedge funds short-selling it.

What is Short Selling?

When trading stocks, an investor can be either long or short on a name. Traditional stock buying refers to long buying, meaning you purchase shares at the price listed and hold until the share price has appreciated enough to earn the profit preferred.

Short selling, on the other hand, is a trading strategy that speculates on the decline in a stock price. Investors are “long” on stocks they believe will increase in price, whereas investors “short” stocks they believe are overvalued.

Traders may use short selling as a tool for speculation, as mentioned above, or they may use it as a hedge against the downside risk of a long position in the same security. In short selling, a position is opened by borrowing shares of a stock, believing they are overvalued. The investor then sells these borrowed shares to buyers willing to pay the market price.

Before the borrowed shares are returned, the trading is betting that the share price will continue to decline and they can purchase them at a lower cost. The risk of loss on a short sale is hypothetically unlimited as the price of any asset can, in theory, rise infinitely.

For example, consider a trader who believes that XYZ stock, priced at $50, will decline over the next 3 months. This trader can borrow 100 shares and sell them to another investor, making this trader “short” 100 shares as they did not actually purchase them.

In this example, if the stock price falls to $25 shortly after, the trader can decide to close his position and buy 100 shares for $25 on the open market to replace the borrowed shares.

Excluding interest and commissions, the trader’s profit on this short sale is $2500 (Shorted price – Market Price at Sale X # of Shares) = (($50 – $25) X 100 shares = $2500).

On the other hand, if the stock price increases from $50 to $75 and the trader decides to close the short position, their loss on the short sale would be $2500, calculated the same way as above. Here, the trader had to buy back the shares lent at a significantly higher price to cover their position.

What is Short Interest?

Short interest refers to the number of shares that have been sold short and remain outstanding. Per the example above, the short interest of that trader would be 100 shares prior to the position being sold.

Short interest is often seen as an indicator of current market sentiment. An increase in short interest generally signals that investors have become bearish, while a decrease in short interest generally indicates a more bullish sentiment.

Often expressed as a number or percentage, FINRA requires firms to report short interest positions in all customer and proprietary accounts in all equity securities twice a month.

Short Interest Ratio = Short Interest/Average Daily Trading Volume

This ratio indicates how many days it would take for all of a stock’s shares that are shorted to be covered or repurchased in the market. For example, if short interest is 1 million shares and there is an average daily trading volume is 100,000 shares, it will take at least 10 days on average for the shorts to be able to cover their positions.

Timeline of a Meme Stock Cycle

Meme stocks gain popularity and increase their numbers of investors through online conversations. When a stock goes viral on social media, it tends to see rapid price spikes. However, these price gains are often artificial and not indicative of strong company fundamentals, leading them to an almost inevitable crash back to low prices.

In a thread on r/wallstreetbets, one user explained the meme stock cycle as follows:

  1. Early Adopter Phase: a small number of investors pick a stock that they believe is currently undervalued and is being significantly shorted on the public market. They then buy up the stock in large amounts. The stock price slowly begins to rise
  2. Middle Phase: Traders watching the market begin to notice the increase in trading volume. More traders, even those outside of the subreddit, will start buying. Then the stock’s price skyrockets.
  3. Late/FOMO Phase: News of the skyrocketing price spreads on social media and online forums, thus fear of missing out (or “FOMO”) takes hold, and even more retail investors join in.
  4. Profit-Taking Phase: After just a few days, the people who got in on the stock early on begin to cash out. Similar to the buying phase, the selling phase becomes a chain reaction as people fear losing money. At this point, the price will start to go down.

History of Meme Stocks 

Online communities for discussing stock market investing have existed for as long as the internet has, but meme stocks did not take off until 2020, the year Bloomberg declared the “Year of the Meme Stock.” 

Day trading increased in popularity during the Covid pandemic as more people were at home and out of work. TD Ameritrade reported that visits to its website quadrupled from January to September 2020, and trading app Robinhood saw average daily trades of 4.3 million in the summer of 2020.

The First Meme Stock: GameStop

The first stock to get the meme treatment was GameStop Corp (GME), which saw interest spike after YouTube influencer Roaring Kitty’s video laying out the upside potential of GME went viral. This video explained that GME had among the highest short interest in the market, with hedge funds making up the majority of short positions.

Then, in January 2021, the short squeeze that The Roaring Kitty had predicted took place as the price of GME shares skyrocketed to nearly $500 amid a panic of short-covering and panic buying.

At the start of January 2021, GME was priced at $17.25, a price that had remained steady for nearly a year prior. On January 26, GME reached $147.98 at the close of market.

On January 26, Tesla CEO Elon Musk tweeted a link to /r/wallstreetbets with the caption “Gamestonk!!” Then just one day later, the stock more than doubled to $347.51, then reached a high of $483 on January 28 before dropping to close the day at $193.60.

This timeline emphasizes how quickly the cycle of meme stocks begins and is completed:

The central victim of this squeeze was a small number of hedge funds, some of which were forced to shut down due to heavy losses. 

The Next Meme Stocks

r/wallstreetbets took off after the success of GME. Users of the subreddit identified other low-value stocks with heavy short interest. Some of the identified stocks included AMC Entertainment Holdings Inc. (AMC), Blackberry Limited (BB), Bed Bath & Beyond Inc. (BBBY), Hertz Global Holdings Inc. (HTZ), and Robinhood Markets Inc. (HOOD).

AMC and BB both saw their shares rapidly increase by multiples shortly after the subreddit noted them as potential gains. Other meme stocks have seen much worse outcomes.

Ultimately, these stocks are picked not for strong corporate fundamentals, but instead based on the trading sentiment of institutional investors. Meme stocks are not intended to be held as long-term positions, but instead for short-term gains based on the timing of the short squeeze.

The Aftermath of Meme Stocks

One major outcome of the meme stock saga of early 2021 has been an increase in the popularity of retail investing. Since the success of the GME short squeeze, retail investor market participation has continued to trend upwards with the share of total equities trading volume approaching 25% in 2021, up from 20% in 2020. The introduction of beginner’s apps with low fees has also incentivized a larger group of people to start investing by demystifying the stock market and allowing individuals with as little as $5 to begin trading.

The GME saga also attracted significant legal scrutiny. The House Financial Services Committee and the US Justice Department began investigating the events that led to the surge. Robinhood, among other brokerages, chose to restrict trading in GME and some other meme stocks in the short term to help manage the squeeze.

Despite the actions of Robinhood and other brokerage firms, new downloads of those apps skyrocketed even after the peak of GME hype. The Robinhood app alone was downloaded more than 1 million times in the last week of January 2021.

This increase in daily retail trading activity prompted the US Securities and Exchange Commission to issue an investor alert warning people of the risks of investing in a “hot stock” or “short-term investing based on social media.”

Meme Stocks Glossary of Terms 

Like the world of professional traders on Wall Street, meme stock communities have developed their own specific lingo used in online posts, often included with emojis. Some of those terms include:

  • ATH: An abbreviation for “all-time high.”
  • Apes: ? Members of the meme stock community. The origin of this term is unclear, some have suggested it comes from individual investors banding together to take on the Wall Street elite.
  • BTFD: An acronym for “buy the f***ing dip.” Buying the dip refers to going long a stock after its price has seen a drastic drop in price.
  • Diamond hands: ?? Holding onto a stock despite losses, even heavy losses, due to long-term confidence over the price of the stock.
  • Hold the line: Used to encourage others to keep holding a stock despite high volatility.
  • Paper hands: ?? A derogatory term used against those who fail to maintain diamond hands.
  • Tendies: ?? Short for chicken tenders, refers to profits made from meme stocks.
  • To the moon: ?? The idea that a stock will rise extraordinarily high. This phrase has also taken hold in crypto trading communities, referenced by Elon Musk when promoting his cryptocurrency coin “Dogecoin.”

This material is provided for informational purposes only and should not be relied on as investment advice

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