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The Mistake Investors Are Making With Meme Stocks

By Boris SchlossbergStock MarketsAug 12, 2021 07:49AM ET
www.investing.com/analysis/the-mistake-investors-are-making-with-meme-stocks-200598104
The Mistake Investors Are Making With Meme Stocks
By Boris Schlossberg   |  Aug 12, 2021 07:49AM ET
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  • Meme stock strategy exploits market structure
  • Meme stocks rise due to short and gamma squeezes
  • As short interest declines the strategy has less punch
  • Investors could see a sharp reversal in the near future

Meme stocks are the investing phenomenon of the pandemic creating parabolic moves in a handful of equities while making fabulous profits for early buyers. These massive moves are the result of coordinated buying attacks of hundreds of thousands of retail investors that have caught many professional investors from market makers to hedge funds completely off guard. 

The dizzying moves have been extremely successful because they have exploited two aspects of market structure in a novel and brutally efficient way. First and foremost, the Reddit army of “apes” focused on severely hobbled, heavily shorted equities such as GameStop (NYSE:GME) and AMC Entertainment Holdings (NYSE:AMC).

Since shorting a stock has the exact opposite risk profile of the long position (the reward is limited to the price of the stock, but the risk is theoretically infinite as the upside is uncapped), the hundreds of thousands of retail traders on Reddit were able to engineer coordinated short squeezes on the selected stocks, sending endless streams of buy orders into the marketplace which lifted prices to such a high point that they were able to nearly bankrupt large fundamentally driven hedge funds, like Melvin Capital, which had to be rescued by hedge fund titan Steven Cohen.

The short squeeze strategy was further aided by the leverage power of options. In addition to making equity trading free of commission, new digital brokerages, such as Robinhood (NASDAQ:HOOD), also enabled millions of new investors to speculate in the derivatives markets by allowing easy access to options. With options, investors could increase their buying power by up to one hundred fold as each option contract represents a claim on one hundred shares of stock.   

As hundreds of thousands of retail investors bought call options in names such as GameStop and AMC, professional market makers such as Susquehanna, Citadel, and Wolverine, were obligated to be on the opposite side of that trade. In order to control their risk option, market makers were forced to constantly buy the meme stocks in a process known as delta hedging, which in turn fueled the buying frenzy and created a virtuous up cycle for the meme stocks.

This combination of short squeeze (investors buying back the stock to protect from unlimited loss) and gamma squeeze (option market makers adding to the buying in order to balance out the exposure of their books) have been responsible for the success of the meme stock strategy. But since this is a strategy that relies solely on the exploitation of market structure, rather than any fundamental value, it is very vulnerable to a reversal and collapse.

Meme stocks such as AMC and GameStop are essentially worthless businesses whose best case scenario is the very slight chance that they may eventually survive as modestly profitable companies serving a tiny niche market. Both companies provide a service that is effectively useless in the modern day and age, with AMC technologically replaced by streaming and advances in home theater technologies and even social viewing of movies via Zoom. GameStop will become even less relevant as a purveyor of games as 5G technology will make latency and bandwidth issues obsolete. 

The current fair value of each stock is probably one tenth, and perhaps one hundredth, of their current market price, but until the double squeeze phenomenon stops working, meme stocks could easily remain at their elevated level. Nevertheless, the latest data shows that positioning is becoming much less favorable to the strategy.

Short interest has declined from as high as 105% of the float to around 15% today. The price has drifted lower as well, but as short interest compresses further, perhaps even to less than 10% of the float, the buying raids will have less and less power and in fact will allow market makers (whose exposure risk will diminish) to stage selling raids which will create forced liquidation of retail accounts in the form of margin calls and will wipe out a good portion of retail capital.

Retail investors, therefore, are now in the position of being a lobster, not feeling any pain because prices of their positions remain elevated far above fair market values, but very much at risk of seeing the capital being boiled alive as the game slowly changes without them realizing it.

The Mistake Investors Are Making With Meme Stocks
 

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The Mistake Investors Are Making With Meme Stocks

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Comments (10)
GME Forever
GME Forever Aug 18, 2021 9:42AM ET
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Boris...How much do they pay you to write trash articles? I understand it's hard to survive in this environment...but maybe you should try different career..as you are completely incompetent for stock market..but I guess you know that already :-)
kyle dvorsky
kyle dvorsky Aug 18, 2021 8:00AM ET
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"But since this is a strategy that relies solely on the exploitation of market structure, rather than any fundamental value, it is very vulnerable to a reversal and collapse." Funny how you call out retail but drop this bit in there like that isn't EXACTLY what hedge funds do. Boris Schlossberg? More like Bought Shillberg.
Robert Brown
Robert Brown Aug 16, 2021 6:17AM ET
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The shorts will always win the war. It may take some time but in a year or 2 these to stocks will be worthless!!
Robert Schulz
Robert Schulz Aug 13, 2021 12:11PM ET
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Who is your audience ? Hedge Funds?  You are clearly ignoring the voice of retail investors and no one is chiming with your thought process.
Jeff Bailey
JeffB Aug 13, 2021 12:11PM ET
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Retail is his audiance. He laid out both sides of the trade dynamic. Of course, retail usually gets angry when they suffer losses and the price action reflects the other side of the trade.
Mr Stanley
MStanley Aug 13, 2021 12:11PM ET
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clearly the audience is 'titan' Cohen
Danel Trade
Danel Trade Aug 13, 2021 7:30AM ET
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Yeah, get a grip. It will be volatile and wild and that is why we everyone likes it. Who has time to wait 10-20 years right?
Ron Dwyer
Ron Dwyer Aug 13, 2021 6:32AM ET
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two questions, who hurt you? how much did the hedgecucks pay you to write this?
Adam Wren
Adam Wren Aug 12, 2021 3:24PM ET
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noones on margin here mate. worthless stock? you mean debtless stock with assets and an excelent forward plan.
Kevin Russel
Kevin Russel Aug 12, 2021 12:56PM ET
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vendetta much?
Jarrett Russell
Jarrett Russell Aug 12, 2021 10:16AM ET
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yep I'm boiling alive in my big fat gains
Jarrett Russell
Jarrett Russell Aug 12, 2021 10:15AM ET
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it's like they find pre schoolers around the world and ask then to write a report about how they feel about certain stocks in the market and if they respond then they are given the title "analysis"
 
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