The Internet has changed the dynamics of everyday life and led to many situations that were previously impossible. It has allowed for almost instantaneous communication among tens of millions of people and ushered in trends and influencers.

One trend that could not exist without the Internet is the “meme stock” phenomenon. While hot stock tips came through magazine and financial news stories in the past, the Internet made the meme stock possible.

A meme stock gets the attention of potential investors or speculators as a result of social media. Interest is further generated in these stocks through platforms like Reddit, TikTok or Twitter, or wherever those with an interest in investing come together online.

The meme stock frequently attracts investments from people who are not typically investors or even day-traders. Sometimes those investing in a meme stock see it as a way to trip up big hedge funds; a David and Goliath scenario, but more on that later.

Rushing In Could be a Mistake

There are drawbacks to meme stocks though that often make them a good choice to take a pass on.

Many investors in meme stocks do not have a thorough or competent understanding of the stock market, volatility or basic principles of investing versus speculating. They do not understand fundamental or technical analysis. They are trusting an unnamed source, and that person’s often-limited knowledge of these prerequisites, for stock investing information.

The stock may continue to move up on the momentum created by the social media frenzy. But, just as quickly, the stock can have the rug pulled out from under it.

Many of the meme stocks of the recent past have relied on a situation called a “short-squeeze.” In the case of many of these stocks, there have been a large number of investors holding a “short” position in the stock and the meme stock investors thwart their strategy.

When investors, including institutional investors like hedge funds, take a short position, they anticipate the stock price to drop and they make money when it does. If meme stock investors jump into the market and buy that stock, it can put those with a short position into a bad position, forcing them to exit their positions.

When this happens, it can cause the stock price to increase further. The short-sellers often buy more of the stock to offset their loses and this causes a jump in the stock price and upward momentum.

The stock of retailer Bed Bath & Beyond is a recent example. Meme stock investors starting piling into the stock in July and boosted the stock 400 percent before the stock’s largest investor liquidated his position and the stock dropped 40 percent in one day. Later, the stock got another bounce when news of a financing deal was in the works.

Not only are meme stocks potentially bad for novice investors, but they can be bad for the Nasdaq as well. According to Jim Cramer, host of Mad Money, the frenzy created around meme stocks impacts the broader market; especially the tech-heavy Nasdaq.

There is even an ETF devoted to this group of stocks. The Roundhill Meme ETF tracks a number of popular meme stocks. The only challenge from tracking this group is that many meme stocks are short-lived.

The moral of the story is that if people online are talking up a stock, or they believe that enough people working together can create upward momentum, then tread carefully. What is artificially inflated can return to reality quickly.

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