Meme stocks and the short squeeze

When a company gets beaten down, investors may take short positions in the company's stock. As an example of a short position, an investor borrows the stock of ABC Company and sells it when the price is $100 per share. The investor hopes the stock price falls, say to $40 per share. At that point, the investor buys the shares in the market and returns them to the lender, pocketing a gross profit of $60 per share. The net profit would be lower, after accounting for the interest paid to borrow the shares, commissions to buy and sell the shares and capital gains taxes on the increase in value of the short position.

So far, we've described a regular short position, where the share price has likely declined for a while. Now let's say crowds of speculators, influenced by social media, start to buy the shares of a beaten-down company. This causes the share price to rally and creates momentum on social media for more speculators to buy, possibly attracted by the narrative of making money at the expense of hedge funds and other large investors who are often on the short side of the trade. Short investors may then need to cover their positions by buying the stock, since they lose money when the share price goes up. When a large number of short investors rush to cover their positions at the same time, this can create an even bigger surge in the stock price — the short squeeze. The rapid rise is typically followed by a dizzying drop. This is because the gain in share price was caused by speculation, rather than any real change in the company's position.

A starting point to identify stocks with some likelihood of a short squeeze is to look at short interest. This indicates the percentage of short interest in a company's stock, relative to all shares outstanding. For example, short interest of 10% indicates that 10% of a company's outstanding shares are held in short positions, while the remaining 90% are held in long positions. Typically, short interest of 10% would be considered high, while 20% would be considered very high. Short interest may accumulate in companies with high debt, negative earnings and a weak outlook for the industry — quite possibly, the opposite of what investors would look for in a long position. Investors might want to look for a level of short interest that isn’t declining and preferably increasing, since a declining level of short interest may enable short investors to cover their positions without actually triggering a short squeeze.

In addition to short interest, investors can look at short coverage. For example, if 100,000 shares are held short and average daily trading volume is 20,000 shares, it could take five days for shorts to cover, a typical minimum level investors might look for when identifying candidates for a short squeeze.

But this is only the starting point to screen for opportunities. Consider that to identify a short squeeze, you need to find beaten-down stocks that are likely to surge in price. Broadly speaking, there are three ways to do this: 

• Fundamental analysis – Fundamental analysis is intellectually hard, because you need to find clues that haven’t been recognized by the analysts and professional investors following the stock.
• Sentiment analysis – Sentiment analysis is hard in a different way, because you have to make sense of posts, videos or memes on social media, often from anonymous users whose knowledge, affiliations and motivations might be unclear.
• Technical analysis – Technical analysis can provide clues for short squeezes, sometimes confirming or even anticipating shifts in fundamental and sentiment indicators. Technical tools to consider include the Relative Strength Indicator (RSI), Moving Average Convergence Divergence (MACD) and one-day price change.

The art of the short squeeze consists of interpreting fundamental, sentiment and technical indicators, then executing buys and sells as the stock price moves very quickly.

Let’s put aside meme stocks and short squeezes for a moment and think in general about the possible edges that an individual investor might have over large institutional investors. Then we'll return to the question of trading meme stocks.

Time edge

Perhaps the most important edge an individual investor has over large institutional investors is the potential to follow an investment conviction for the long term. Professional managers run the risk of being fired by clients or pressured by investment committees for just a few quarters of underperforming a market index or benchmark portfolio, while individual investors can stay with an investment for years or even decades — as long as they can stomach. While individual investors can often be distracted by much shorter-term movements in the markets, the potential remains for them to play the long game.

Psychological edge

An individual investor can be more independent and open-minded than large investors, where team-based approaches and committee-based decisions are the norm. This can give individual investors an important psychological edge in investing, since cognitive and emotional biases can be hard to detect and resist in group settings.

Risk edge

An individual investor can take more risk than a large institution, say with an early stake in a technology company. This is partly because of size: an individual can reasonably commit 5-10% of a $1 million portfolio to a high-conviction opportunity, while this can be next to impossible for an institution with a $100 billion portfolio.

These edges become even more powerful in combination — when an investor makes a strong commitment to a promising opportunity, when the opportunity is unrecognized or unpopular and when the investor is willing to follow their conviction for a long time. 

Now let's explore what happens to these edges when investors trade meme stocks. When it comes to their time edge, investors have shifted away from positions that they could hold for the long haul, instead holding for days or weeks. When it comes to their psychological edge, investors have become exposed to groupthink, through the herding behaviour of speculators and traders on social media platforms. And when it comes to their risk edge, investors, instead of taking relatively larger positions than others can accept, are now likely investing relatively small amounts in high-volume stocks.

This raises a broader point than meme stocks. Rather than start with the investment, investors can start with themselves and reflect on whether the investment allows them to play to their strengths. Warren Buffett has talked about the importance of having a "circle of competence" and investing within that area. This is a similar point about a "circle of advantage" — an edge that each investor can define for themselves.