I can calculate the motion of heavenly bodies, but not the madness of people.
-Issac Newton, after losing $3 million in today's dollars in the South Sea Bubble.
The modern perception of the stock market (until 2021) was often that it's a boring place to buy index funds with 401k contributions. However, if you study history, financial markets were a testosterone-fueled spectacle for almost all of their existence. There isn't anything inherently wrong with speculation, just as there isn't anything inherently wrong with investing in index funds. This said, financial market bubbles, especially those associated with groups attempting to corner a market have been shown to result in large redistributions of wealth. In the past, this almost always has boded poorly for new entrants with limited education in the financial markets.
The simplest way to explain what's happened in meme stocks is that retail traders and hedge funds trading on momentum have cornered the market in heavily shorted stocks. Cornering a market is when you gain enough control over the supply of something to be able to set the price. In order to do this in a free market, you inherently have to pay prices that don't make economic sense in order to force someone else to pay more than you do afterward (typically jamming someone who is short what you're long in the case of a short squeeze to buy, or in the case of physical commodities, end-users). Then you have to sell at inflated prices, which will work to bring the price back down. For this reason, the vast majority of attempts to corner a market will fail in the long run, in life and art. In Trading Places, the 1983 classic starring Eddie Murphy, the villains of the movie go broke trying to corner the market in frozen orange juice.
Trading Places, 1983.
Where a lot of people seem to run into trouble is when they made trading decisions based on external motivators like revenge, populism, or proving people wrong rather than investing using methods like fundamental analysis, momentum, etc.
GameStop Stock Vs. Ancient Greece
To this point, there are a lot of people who aren't very educated in the markets putting life-altering amounts of money at risk in the short squeezes in GameStop (GME), as well as AMC Theatres (AMC), Koss Corporation (KOSS), and other highly speculative names. Prior to the run-up in these stocks, I sometimes would read incredibly detailed due diligence posts on Reddit, accompanied by screenshots of the user's call option positions. Now, the due diligence is mostly drowned out. There's a big difference in the financial education level of the people who bought GameStop stock at $10 and those who bought for $300, so hopefully, people understand when to sell, because there isn't a ton of room to be late in a market-cornering trade.
The first notable incident of market speculation is often attributed to Thales of Miletus, a Greek philosopher and astronomer. Thales used his astronomical knowledge to predict the olive harvest, then went and bought up all the olive oil presses. When the bumper crop of olives came, Thales was able to name his price for the use of the presses, making a small fortune in the process. Aristotle later noted when writing about Thales that the scheme would have worked with even an average harvest. Over the next 2500+ years, these same basic mechanics of market corners played out over and over again.
Olive Press–Source: Find in Greece
In 1923, Edwin Lefevre wrote the classic book on stock market speculation–Reminiscences of a Stock Operator. The book is based on Jesse Livermore, who made over a billion dollars in today's money speculating in the stock market, only to go bankrupt later. Lefevre noted that very few people who try to corner a market end up succeeding. An alarming percentage of market corners historically end up with people going broke, going to jail, or committing suicide. If you read the history, you literally can't make some of this stuff up. There is still a law on the books banning onion futures after a couple of traders in Chicago cornered the onion market in the 1950s. The Hunt brothers, some of the richest people in Texas at the time, bought a significant amount of the global supply of silver in the late 1970s and arranged for their heavily armed ranch hands to fly it to Switzerland. They then bought futures and demanded delivery from short-sellers who could scarcely find any silver left to deliver, driving the price to the moon before the exchange intervened on Silver Thursday in March 1980. They would later file for bankruptcy, although their personal assets were largely protected by trust funds. More recently, Porsche cornered the market for Volkswagen stock in 2008. In the end, there's nothing new under the sun when it comes to short squeezes.
Is It Okay To Speculate on Stocks?
I personally think there isn't anything inherently wrong with speculation. I'm 1/1 on large options trades and I got away with taking an excessive amount of risk as a 19-year old. Issac Newton was less lucky when he lost all his money in the South Sea bubble, and he's clearly smarter than me. Thankfully I could learn from my mistakes without my mistakes costing me my principal. I bought ~100 contracts of Apple call options between December 2014 and January 2015 and ended up making a little over $20,000 in profit. I would have made 4-5x more if I had held on a few more weeks, and more still if I had just bought and held Apple until now, which was extremely cheap at the time. I did do extensive due diligence on the trade, much of it from Seeking Alpha, and I figured Apple was worth at least 50 percent more than its market price at the time. But I started in the market as a pure value investor prior, scoring multipliers on stocks like Bank of America, Union Pacific, and Cerner.
My fear is that thousands and thousands of people are going to buy meme stocks at the top, sell at the bottom, lose a bunch of money, and decide investing isn't for them. That's not the message that people should take away from these short squeezes because there are great opportunities to make money out there by buying undervalued companies and finding niche investments in various asset classes. I'm not always right and you probably won't be either, but if you stay invested and can manage to get educated enough to be in the 20 percent of people who make 80 percent of the stock market gains, then you can make amazing amounts of money by investing. My advice to anyone who still has a healthy profit in popular short squeeze stocks is to at least take your original investment off the table and invest in companies with solid cash flow, broad market ETFs, or both.
I've speculated on stocks and options and made money. I wasn't a very good risk manager when I was younger, if I were starting over I would have studied risk management first and run my portfolio like a business, focusing on minimizing expenses and managing risk more. Once you get better at managing risk, you often find that you can take more risk on average than you used to when you were worse at managing it. I stopped short selling stocks when the vaccine came out, and I think that the lesson I've learned from the drama over GameStop is that short selling just isn't for me. Despite all of this, if you know the basics and have plenty of time, the stock market is fairly forgiving–I had the good fortune of being able to make plenty of mistakes and turn a nice profit. My hope is that the stock market craze of 2021 helps more people than it hurts and that my readers are responsible with their investment/trading decisions.
Did you enjoy this article? Follow me for future research updates!
