Meme stocks are the investing phenomenon of the pandemic creating parabolic moves in a handful of equities while making fabulous profits for early buyers, explains Boris Schlossberg of BK Asset Management.

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 and 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 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 also enabled millions of new traders and 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 traders bought call options in names such as AMC Entertainment Holdings Inc. (AMC) and Gamestop (GME), 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 GME 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%. 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.

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