ContributorsPublishersAdvertisers

What is a Meme Stock? (A Guide for the Curious Investor)

FinanceBuzz
FinanceBuzz
 2022-12-08
https://img.particlenews.com/image.php?url=3aaDGV_0jbtD4Au00

FinanceBuzz is reader-supported. We may receive compensation from the products and services mentioned in this story, but the opinions are the author's own. Compensation may impact where offers appear. We have not included all available products or offers. Learn more about how we make money and our editorial policies.

Meme stocks are stocks that become popular on social media. This popularity may lead to an increase in the value of a stock, but typically not in a predictable or lasting way. The value also tends to have little to do with the actual success of a company.

Although meme stocks might sound simple, there is more to how they work and why they’re generally considered riskier than your average stock.

What is a meme stock?

A meme stock is an actual stock that represents a share of a company. This stock trades as any other shares on public stock exchanges. Buying a stock in a company gives you fractional ownership of the company.

But meme stocks differ from everyday stocks in their connection to social media. A meme stock typically becomes popular on social media, which may draw investors to the stock and potentially increase its value.

Meme stocks may also be stocks that many investors are short selling, which means these investors are betting the stocks in question will drop in value.

Regular stocks vs. meme stocks

Some regular stocks are popular because the companies they’re connected to are successful and well-known.

For example, tech giants such as Google (NASDAQ: GOOGL), Apple (NASDAQ: AAPL), Tesla (NASDAQ: TSLA), and Amazon (NASDAQ: AMZN) have generally seen huge increases in their stock values in the past decade.

This isn’t surprising because these giant companies have a global presence and are quite successful in their industries.

But meme stocks are often connected to companies that aren’t as profitable, at least at the time. They can be companies that were more popular years ago, which can create a nostalgic feeling for social media users.

Examples of a few companies that have had some of the biggest meme stocks in recent years include video game retailer GameStop Corp. (NYSE: GME), movie theater chain AMC Entertainment Holdings (NYSE: AMC), mobile phone manufacturers BlackBerry Ltd. (NYSE: BB) and Nokia Corp. (NYSE: NOK), and home merchandise retailer Bed Bath & Beyond Inc. (NASDAQ: BBBY).

How do meme stocks work?

Meme stocks typically benefit from social media attention, which may drive up the value of the stocks. Let’s explore how it works in more detail.

Betting on undervalued stocks

Meme stocks often involve companies that Wall Street investors have written off. In other words, hedge funds and big investors view the stocks of these companies as not investment-worthy. That is unless you’re doing specific types of investments, such as a short sale.

Executing the short sale begins by borrowing shares of a stock and then selling them on the market. Selling a large share number of a stock may lead to a price drop. Short sellers can then buy the shares at a lower price to give back what they borrowed, and making a profit in the process.

However, individual and retail investors on social media may notice a stock they believe is undervalued, and they begin rallying behind it. The rally can gain more momentum if it becomes a meme, potentially increasing the price of a meme stock.

Going against short sales

Big investors stand to lose money on their short sales if a shorted stock becomes the subject of a meme and its price increases. Social media users may also get excited about the prospect of Wall Street investors losing money, so they may further rally behind such a stock.

As the stock price increases, investors — in this case, hedge funds and Wall Street investors — with short positions experience increasing pressure. They have to pay back the stock they borrowed and sold. However, the higher the stock price becomes, the more money they stand to lose.

Short sellers with large money reserves, such as hedge funds, may attempt to wait for the stock price to decline for their short sale to become profitable. However, the stocks they borrowed for their short come with certain borrowing requirements.

Investors typically need a margin brokerage account to short a stock. Margin accounts often require holding funds equaling 50% of the short position value. For example, short sellers may need to hold $1,000 in a margin account if they want to short sell 100 shares of a stock trading at $20.

As the stock price increases, the margin requirement also increases, which puts additional pressure even on short sellers with large money reserves.

Building up short squeeze momentum

Investors who can no longer maintain their positions due to growing losses and borrowing requirements may begin buying back the shares they shorted to limit the amount of money they stand to lose. However, buying these shares can increase demand and push the stock price up, effectively starting a short squeeze.

During a short squeeze, more and more short sellers give up, accept their losses, and buy back the shares they shorted as the share price skyrockets for the remaining short sellers. The short sellers who don’t give up are then forced into a game of chicken to see whether they can outlast the trend while fulfilling their borrowing requirements.

This short squeeze scenario can lead large short sellers to lose money — sometimes millions or billions of dollars. Meanwhile, people on social media who rallied behind this stock early on may profit from the price increase.

A brief history of meme stocks

The meme stock trend essentially began with GameStop in 2021, a video game retail company that had been popular years before. However, it suffered from low stock valuations in 2020.

Investing communities on Reddit (specifically the WallStreetBets, or WSB, subreddit) believed the stocks of GameStop and a few other companies were undervalued. They brought a lot of attention to these stocks and began buying them on low-fee investment apps such as Robinhood.

These retail traders also noticed that GameStop stock and a few other stocks were heavily shorted by Melvin Capital, a large hedge fund worth more than $12 billion at the beginning of 2021. Melvin shorted GameStop, which means it bet that stocks of GameStop and other companies would continue losing value.

GameStop stock traded between less than $1 and about $5 per share in 2020. However, due to the hype, its trading volume rapidly increased, and it climbed above $80 per share in January 2021.

While Reddit users are considered the primary catalyst for the GameStop price increase, there were also several other factors. This includes the COVID-19 pandemic, money available from stimulus checks, Elon Musk tweets, and heavy news coverage.

The Melvin Capital hedge fund didn’t account for this meme stock frenzy. It ended up losing 53% of its portfolio in January 2021 due to its short-selling bets on stocks of GameStop and other companies.

Meme stocks continued to be all over the news in 2021, but their popularity has declined since the initial frenzy. GameStop's share price hovered around $23.80 as of Dec. 8, 2022.

Should you invest in meme stocks?

Whether you should invest in meme stocks depends on your investment experience and risk tolerance. Any investment comes with a degree of risk, but meme stocks can be especially risky and volatile.

This volatility means their values can fluctuate dramatically over short periods of time in unpredictable manners. This is because their values are often tied to attention on social media platforms rather than the actual success of a company.

This is why getting investment advice from social media can be a risky practice. This is well reflected in how experts rate TikTok personal finance advice, which can be hit or miss.

Before investing in any asset, consider learning how to invest money and how to invest in stocks online. You should have an investment plan with clear investing goals. It’s also essential to know about the fees and taxes you may have to pay.

Meme stocks FAQs

How risky are meme stocks?

Meme stocks are considered extremely risky investments. This is because these stocks tend to receive value from their trending popularity on social media. In general, as a meme stock becomes more popular, its value may increase. But the popularity may eventually decrease, resulting in a plummeting value. This could all happen over a relatively short period of time.

Do you have to pay taxes on meme stocks?

Yes, you typically have to pay taxes on meme stocks or any other type of similar investment. The general rule is that you have to pay short-term or long-term capital gains rates on any stock you’ve owned, depending on whether you held the stock for less or more than a year.

Are short squeezes legal?

Short squeezes are legal when they naturally happen. However, short squeezes aren’t legal when they’re the result of an intentional plot or scheme, according to the U.S. Securities and Exchange Commission (SEC). In general, stock market manipulation is considered illegal. But short squeezes can still happen naturally in the market, so you would have to consider the circumstances surrounding a particular short squeeze to determine its legality.

Bottom line

Meme stocks are real stocks that have typically received an inflated value due to their popularity on social media. This value doesn’t often align with the actual success of the company that issued the stock. That’s why meme stocks are considered risky investments because their values can experience huge fluctuations over short periods of time.

New and individual investors may benefit from safer investment assets that are less volatile. Check out our list of the best investment apps to explore the assets each app offers and find a platform that provides the tools you need.

Public Benefits

  • Get $3-$300 in free stock when your account is approved*
  • Invest in 1000s of stocks and ETFs with fractional shares—no account minimums
  • Follow friends in a social feed and learn from a diverse community of investors
  • * Free stock offer valid for U.S. residents 18+. Subject to account approval.

Comments / 0

Comments / 0