Meme Stock Risks

“There’s a problem with the memes (a stock that has gone viral online, drawing the attention of retail investors) because the people who are investing will lose a very substantial amount of money.” Thomas Peterffy

Definition: A meme stock is a stock that has seen an increase in volume not because of the company’s performance, but rather because of hype on social media and online forums like Reddit. For this reason, these stocks often become overvalued, seeing drastic price increases in just a short amount of time.

The big problem with the so-called “meme”stock, which are assets powered higher on social-media sentiment and not on fundamentals, is that inexperienced investors will be saddled with real losses when stocks like AMC Entertainment Holdings (AMC), and GameStop Corp. (GME), eventually come back down to Earth.

The escalation in the values of these companies, like AMC and GameStop, don’t align with their prospects for earnings or revenue in the near or midterm.“There’s a problem with the “memes” because the people who are investing will lose a very substantial amount of money,” Thomas Peterffy, founder and chairman of Interactive Brokers Group Inc., said.

Peterffy said that the good thing about the surge in memes is that it will likely bring more young investor into the fold, but they will likely learn a hard lesson in the process.

Selling Short and short squeeze

Selling short means investors are betting that the asset will fall in value. The investments in AMC and GameStop originally started out as organized short-squeezes by a cadre of individual investors who had identified that a number of companies were heavily shorted by hedge funds, according to MarketWatch. These individual investors surmised, correctly, that those stocks could be pressured higher if enough buyers collectively swooped in.

A short squeeze is when many investors looking to cover short positions start buying at the same time. The buying pushes the share price higher, making short investors accelerate their attempts to cover, which sends the shares spiraling higher in a frenzy.

Short sellers, who bet a stock will fall, provide potential fuel for stock rallies when they’re wrong. If the stock jumps, instead of falling, the short sellers are forced to buy the stock to stop their losses from growing.

Lesson learned

Trying to identify a fundamental narrative that can justify meme stocks’ price and market cap are admittedly difficult. Still, it is an exercise that might provide some insights for meme stock investors. Essentially, when the music stops for the meme stocks like AMC and GameStop, investors could be looking at big capital losses.

References:

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