Written by Andrew Cassar Overend
8 min read
Last Updated on June 11, 2021
The start of 2021 has proven to be one hell of a ride for investors. From inflation jitters causing mini-tech sell offs, to a meme-led crypto craze, to Reddit-fueled overnight gains in insolvent company stocks, it seems that the time-tested principles of sound investing have been long forgotten. Over the last few weeks, we have witnessed the second in a series of rapid price surges in so called meme stocks
These irrational price developments are a manifestation of what is known as the greater fool theory. This happens when someone buys an asset irrespective of the price relative to its value with the hope that there will be a fool greater than him/herself who is willing to buy the stock in the future at a higher price.
Here’s how these price swings play out:
A group of people (say the Reddit “wallstreetbets” group) agree to flock into a cheap, heavily shorted stock like AMC or GME. They get the attention of the media which makes a big deal out of the news. The media coverage generates increased interest and participation in the hype, leading to more buying, in some cases using leverage.
Professional investors are unable to digest these irrational upswings and continue to bet against the price rise by using options to short the stock
This self-perpetuating cycle goes on as long as those who participate in the frenzy find “a greater fool” to sell the asset to at a higher price. But eventually this cycle breaks. This happens when those early participants make a considerable gain on the stock and decide to realize profits by selling the stock. When these individuals sell the stock and there are insufficient buyers, the stock tanks.
The reverse process then occurs. The selling frenzy gains media coverage. Investors continue to sell as fear takes over and weak money drives out of the stock until the price of the stock restabilizes itself at a considerably lower price from its previous peak.
The driver of this madness is a confluence of factors, including emotion, the availability of liquidity, social media contagion and cheap trading platforms.
Most retail investors started participating in the equity market due to lack of better things to do during the widespread lockdowns imposed in 2020. From that point till today, the ample liquidity provided by policymakers to combat the pandemic propelled equities to all-time highs, boosting the morale of the average retail investor and giving the false perception that making money is easy. I call this the dopamine
This liquidity effect was further propelled thanks to cheap trading platforms like Revolut or Robinhood which were successful in making financial instruments easily accessible to retail investors.
Another notable source of this equity frenzy is social media. Millennial investors have been brought up in a digital world in which our behaviour is highly influenced by social media. Social media has brought along numerous benefits like freedom of expression, but it has also cultivated an abundance of misinformation which makes it harder for the average investor to separate the wheat from the chaff.
Despite the irrational moves in the stock it doesn’t mean you cannot benefit from the large price swings. You can either buy the meme-stocks with a stop loss and a predetermined target exit price or use options to take advantage of the volatility in the stock. If you manage to identify where the capital is flowing into and when to get out, then you can benefit from short term price gains.
Let’s use AMC as an example.
While I do not suggest buying AMC as an investment because of its weak financial position, if you decide to do so it is important to understand that you are speculating, not investing. Therefore, you should only put in an amount of money that you are willing to lose. The probability of making money is equally as likely as the probability that you will lose your money.
Next, conceptualize the target price at which you will sell the stock if it happens to be reached, and be sure to stick to it - do not be greedy. Keep in mind that low prices require less flows of capital to prop up the price. At $10 per share, AMC required less capital to double to $20 per share than it took for it to further double to $40 per share.
Don’t forget to set your stop loss! If you do not happen to be stopped out because of an unprecedented blip in the stock, then hang in there for a few days just in case momentum reverses back in your favour. If the price never happens to recover, then it shouldn’t be a big deal for you given that you’ve put in a sum which you were willing to lose. However, from the last meme-stock episode of the sort last February, the prices of stocks like Gamestop, AMC and Blackberry never returned to their pre-mania levels.
With that said, the best way to participate in the hype is using options. You can either buy out of the money calls
But you can take an educated approach to short selling. A neat strategy I came across from the renowned trader Adam Khoo is to sell extremely out of the money puts
Since AMC is a loss-making company, the true net worth of the company cannot be inferred using conventional techniques like the Discounted Cash Flow. A metric which is frequently used to value a loss-making company is the industry Price to Sales ratio. If we multiply the industry average price to sales ratio of 8.27 by the revenue per share of the company of 2.35, we get a fair value of around $19.4.
The following image shows you the calculation of the average price to sales ratio for a few of AMC's competitors:
This screenshot from YahooFinance shows from where I derived the Price to Sales ratio and the Revenue per share metric:
Let’s say you sell puts at a strike price of $12, which is the price at which the stock fluctuated around before the hype started. It is unlikely that the price of AMC stock falls back down to under price at which the hype started, and we have the last meme stock mania last January to vouch for this (as shown in the above chart). Now if the trade works out in your favour and the stock price has more room to run, then you will earn the premium at expiration.
But in the unlikely case that the trade does not work out in your favour, assuming you sold short 1 options contract, then you are forced to buy 100 shares of AMC, so your total outlay is 100 x $12 = $1,200. But since we found that the intrinsic value of AMC is estimated to be around $19.4, then you are still grabbing a fair deal at $12.
This is not a recommendation, but it is simply an interesting strategy I came across by a highly experienced investor and you assume full responsibility for the risks involved.
Should you choose to participate in the meme stock frenzy, whatever you do, do not get emotionally attached to the trades you make. If you find yourself continuously monitoring price developments or have a hard time sleeping at night, then you are emotionally attached to the trade and you should get out at the first opportunity to do so. Also, avoid using leverage and only risk what you can afford to lose.
On a concluding note, it seems that over the past year, investors (particularly millennial investors) have become considerably impatient. Long term investing is perceived to be boring and old school. Face it, why should you park your capital in financially sound companies with stable growth when you can benefit from a 50% price increase by investing in a meme stock?
It may be hard to digest at this point, but at some point all non-fundamentals-based asset movements eventually revert to normality. Never lose sight of your long-term goals which can only be achieved through smart investing, and not get distracted by the unsustainable short-term noise. This is a very challenging market environment to participate in so remember, it is never shameful to sit on the sidelines. After all, the great Warren Buffet’s #1 rule of investing is to not lose your money. On that note, invest diligently, be patient and trust the process.
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