Meme stock investing came to be in January 2021 when out of favour stocks such as Game Stop, AMC and Blackberry suddenly saw huge price increases in a very short space of time.
Retail investors came together and organised themselves in online forums such as the Wall Street Bets Reddit page and took on the institutional investors at their own game and won. This completely flipped the playbook for retail investors who normally were at the mercy of market manipulation by these institutional investors.
There was one thing in common between all of these stocks that suddenly became the potential to be meme stocks, and this was that they all had a high short interest.
Short Interest Explained
Investors usually profit when the price of a stock they have invested in increases – this is taking a long position on a stock. Similarly, an investor can also profit from the price of a stock falling by taking a short position or shorting a stock.
Institutional investors especially will short a stock they believe from their analysis will fall on hard times due to several factors that could be poor leadership/vision and business lines readily becoming outdated for example.
The short interest ratio is often used as a measure of how much of a bet is being made by the market that the particular company’s stock is going to fall.
It is very easy to calculate the short interest ratio of a stock, it is simply:
For example the short interest of Bed Bath & Beyond Inc at the time of writing can be calculated as follows:
Making up the first half of our formula is the short interest – this is the total amount of shares which have been shorted on BBBY equal to 30,617,290.
The second half our formula is the take the float of the company which equals 76,035,055 – a company’s float is the total amount of shares available for trading by the public and will exclude any shares that are not available on the secondary market such as restricted stock which may not be publicly traded.
Lastly then we just divide one by the other 30,617,290 / 76,035,055 = 40.27%.
Resources such as Marketwatch have a chart that you can view at any time that keeps track of the most shorted stocks on the market at the moment.
Since the popularity of meme stock investing began, any company that found itself at the top of this short interest ratio ranking, has often become a candidate to become the next target of the meme stock investing community. Next up, let us find out exactly why this is the case.
The Short Squeeze
When you buy a stock or open a long position your potential downside on that investment is limited because naturally enough the price of the stock cannot decrease more than 100% or fall below zero.
This is not the case when you short a stock (or crypto for that matter), there is a potentially unlimited downside as you lose money when the price of the stock increases and there is no theoretical ceiling stopping the price from rising to infinity and beyond.
This vulnerability of opening a short position was exploited by meme stock investors, they realised that if they could combine their forces and started to put upward pressure on stocks with a high short interest that they could force the price to increase to such a level that it caused the institutions to sustain large losses ( often leveraged positions too).
The pressure caused by meme stock investors was so great that the institutions had to close (cover) their positions to prevent them from sustaining even bigger losses.
The act of closing their position meant that the institutions had to buy more of the stock which further accelerated the pace of the rise in the underlying stock price which lead to the parabolic rises we have seen in stocks such as Game Stop and AMC.
Final Thought
Looking for the next meme stock to invest in is not a strategy any financial advisor would suggest to anyone – as it reduces investing to becoming potluck rather than founded on fundamentals. But there is another period of hysteria around meme stock investing then some of the likely candidates will always find themselves on top of the high short interest list.
Disclaimer: This blog post is for informational and educational purposes only and should not be construed as financial advice.
