Updated: Mar 5, 2022
Just when we thought that it was a flash in the pan, the meme stocks are back; 6/3/2021 was the largest trading volume day of the year. Things had been relatively quiet for the past two or three months.
In the winter of 2021, GameStop made headlines when the stock was shooting up exponentially. This caused a frenzy in the market fueled by the Reddit WallStreetBets forum. In the process, some people made huge gains and some hedge funds lost huge amounts of money.
What initially transpired had never happened in the stock market before, but it showed how safety in numbers can be very powerful - David took down Goliath.
A few reasons for this is due to the capability of people to collaborate in online forums and collude on an ideal where the collective group agrees to carry out the same action.
The presumption is that many of the traders are new to the game. The other was the influx of cash brought in through the stimulus checks; and this was coupled with people finding a new outlet during the Coronavirus.
Currently, GameStop is back into the fold and Koss and Bed Bath & Beyond are up over 250% for the year (as of 6/3/2021). A couple of other hot ones are Blackberry and AMC.
What is Short Selling
So to be very simple about the concept, traders place bets on shares and with GameStop it was trading stock options.
To put it simply this type of trading in other words is a legalized form a gambling. It's all about betting which way a stock is going to perform.
When people or entities bet against a stock it's called shorting it. Shorting the stock means that shares are borrowed from a broker on margin, and the broker says I'll give you these shares, but you have to return them later, and pay me margin interest in the meantime. This means when you short the stock or borrow the shares, you want them to go down in price. Why do you want them to go down, you ask? Because, when that happens the investor can buy the same amount of shares at a lower cost if they do; and if that happens, the investor gets to pocket the difference meaning, I sold the borrowed shares at a higher price, betting that the stock is going to go down, because I don't believe in the company’s stability.
Honestly, this is an age old strategy for more sophisticated investors and there is nothing wrong with this. It’s not illegal, but you do have to be fully prepared to deliver the shares back to the broker, because you borrowed them to sell.
The whole point of short selling is betting on, and profiting from, a drop in a security's price. This can be contrasted with long investors who want the price to go up, because they’ve bought them to hold them for growth and potential income.
Short Selling Examples
Here is a loose example for simplicity. Suppose I borrow 10 microphones from Cindy that have a value of $100 each. So then that’s $1,000 in my pocket now because when I borrow them, I immediately sell them to buyers willing to pay $100 for each of them.
Now, on my hunch, I am betting that the market value of the microphones will drop, thinking a better model might come out. So lucky me, they did go down to $80, now I can go back and buy the microphones back for 800.00.
In this example, I would pocket $200, and I’d then deliver them back to Cindy to repay her for the mics I originally borrowed from her to sell at a profit. Now, that worked out great for me, because my prediction that they’d lose value was correct!
So let's do this with the stock where there is a loss to the investor that borrowed stock to sell. Let’s say Netflix currently trades at $500 a share and David borrows 20 shares from me. So at that point in time that means those shares are worth $10,000.
Knowing that the whole point is that you want the shares to go down in price, let's say that the shares shoot up to $600 in price. The shares would be valued at $12,000. So in performing the calculation, the stock is sold for $10,000 but the stock went up instead of down, and now David has to buy them for $12,000 so he can deliver them back to me, and now David is $2,000 in the hole. He has to come up with extra cash out of his pocket so he could buy the shares to give them back to me, and he has to pay me interest in the meantime.
For example, when GameStop had such a run-up in the stock price and the short sellers are losing money, it is due to the fact the stock is being purchased by investors in the open market. This drives the price up, and now those short sellers need to close their position. This means they need to buy up their shares to pay them back to the lender, and this creates more buying in the open market, which then continues to increase the stock price due to the demand.
So in short, if a short seller investor doesn't act quickly when a stock starts rising in value, their stock position just keeps getting more and more into the negative because they have to come up with big dollars to buy them back.
The Difference Between Short Selling and Stock Ownership
The important thing to keep in mind is that short selling is different from owning a stock. If an investor buys 10 shares of Crowdstrike at $100 it's worth $1,000. So hypothetically if Crowdstrike goes bankrupt and the shares are worth $0 the investor is out only $1,000.
With short selling, as long as the price goes up, the borrower will continue to lose money. In addition, the short seller pays interest and other charges. The goal of a short seller is to buy high and sell low.
How Will These Stocks be Traded in the Future?
The interesting thing is that there are only a handful of the meme stocks so this means there are only a limited set of buyers. At this point it doesn’t appear that the amount of people trading are large enough to make an impact on a larger set of stocks.
The interesting thing is that there were enough short sellers that figured they could sneak in under the noses of the meme stock traders and they pushed a few of these stock prices again. The price of GameStop is $221 and was recently at $280. and AMC is $56 and they both have declining business models.
Let’s take AMC: They recently issued a total of11.55 million shares at an average price of approximately $50.85 per share in an at-the-market equity program. By doing this they raise capital to improve the business or pay some bills. On the other hand they are technically raising debt and with a larger share offering, it dilutes the stock’s value. AMC in their 8K stated: We caution you investing in our Class A common stock, unless you are prepared to incur the risk of losing all or a substantial portion of your investment.
There is a sentiment out there that the stock should be valued at $1 per share.
Box office sales peaked in 2002 at 1.58 billion tickets. By 2019, sales had dropped 22% to 1.23 billion tickets, despite 17 years of population growth. On a per-capita basis, ticket sales plunged by 31%.
The average ticket price has increased by 100% since 1997 to $9.16 in 2019 according to the numbers. Over the same period, the inflation index CPI has increased 64%. For a family of five, going to the movies can be an $80 - $100 night when factoring in popcorn, drinks and snacks. That is taxing in many family budgets.
What About the Fundamentals?
All in all, some of the meme stocks don’t stand up to fundamental values of measuring and in time, the likelihood is that these companies won’t be trading at very high prices to that of book value or P/E.
It makes sense, because companies that are stable and have great current and forward looking earnings such as Apple, Microsoft and Facebook will prevail. There is no reason to buy poorly valued companies over high valued ones over the long term.
Let's Do the Meme Stock Recap
What is Short selling? In the simplest explanation: short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
This type of trading with the memes stocks and others is not a normal practice. This is something that is not safe meaning, great you made money; now take your money and run!!
Thus, if your college kid calls to borrow money for this, deny him or her! This means, people are not buying this because it's a solid company. They are buying this because they see others making money, and the stock is irrationally going up.
#3 If you hold on thinking the stock will go higher and stay there, you may be fooling yourself as much as thinking you are on a roll at the craps table. This is called is irrational exuberance meaning, there is unfounded market optimism that lacks a real foundation of fundamental valuation, but instead rests on psychological factors.
Stick to the fundamentals with companies: quality, value, healthy balance sheets with cash on hand and dividend strength. This is how you win in the long-term.
Do your own homework and make your own decision, but the priority in life should be the budget, the emergency fund, rainy day fund, retirement and risk tolerance. If you have all of this in place then great; then use play money and gain a good understanding of what you're doing.