Bubble in Certain Stocks Not the Stock Market

A recent phenomenon in the stock market is causing certain stocks to disconnect with fundamentals and rocket higher. Aggressive investors and gamblers have found a way to game the market using social media. Many are small inexperienced investors trading on the RobinHood platform. Using the popular website, Reddit, traders are identifying companies with poor fundamentals and high short interest. Once they select their target, they begin buying call options aggressively. Options are derivatives of the underlying stock and provide leverage.

Because so many individuals are following the targeted stock on Reddit, the shares rise exponentially. Companies with high short interest are targeted because those shorts eventually have to be covered. When an investor sells shares short, they are selling shares they don’t own and at some point in the future the shares sold short must be purchased to close out the position. Essentially, short sellers are betting that the stock will drop in value. If the stock goes up, they will have a loss. Technically speaking, the potential loss is infinity because there is no cap as to how high a stock can go. The Reddit traders are trying to force the stock up, in turn forcing the short sellers to buy the shares (because they are losing money). This drives the stock up even further.

Traders focus on buying extremely large volumes of call options which are purchased through market makers. Market makers are in the business of creating a market for investors to buy or sell securities. With so much volume on one side of the trade, the market maker needs to hedge the risk by buying the security. Otherwise, a sharp rise in the stock could put the market maker out of business. This also drives the stock up even further.

A recent example of this is GameStop (GME). They are a company with poor fundamentals and very high short interest. By using the methods described above, the stock rose more than 100% last week, 50% on Monday, January 25^th and another 93% on Tuesday. Over the last month, the stock has rallied over 600%. At this point, the gaming of the system appears to be allowed because of free speech. Clearly the SEC will take a look at this now that it has proven to be a viable method of manipulating the market. This will end badly because the companies being targeted are dying. For most people, this gamble will end like most other gambles.