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Beware Trading in "Hot" Stocks

| January 27, 2021
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There have been a number of anomalies in the stock market during 2020 which appear to have carried forward to 2021. Small traders have become more active in the market often causing the prices of smaller, thinly traded stocks to surge or collapse very quickly. There are a number of reasons for these dramatic price changes which do not appear to reflect any company fundamentals. These trends have turned small corners of the stock markets into speculation vehicles for gamblers rather than efficient investment markets.

One of the factors that has caused the wilding trading in certain shares is the popularity of online message boards. In some cases, small investors have used these message boards to coordinate their trading. So, whereas a small investor would typically not have enough money to impact the price of an investment, thousands of these small investors coordinating their efforts can cause stock prices to rise or fall quickly. An extreme example is a company that declared bankruptcy in 2020, an action that would likely make the stock value worthless after the bankruptcy proceedings, yet its stock price increase over 500%. This was clearly due to short-term speculating by inexperienced investors as most market experts believed that the shares were worthless. As expected, the stock price soon fell back to previous levels.

Some online trading platforms that market to younger investors and those who have small amounts to invest have also encouraged in the increase in price volatility in some shares. Many of these trading platforms use leaderboards to show which stocks are trending up or down and which shares have been the most traded by investors on their platform during the previous days or weeks. These tools are designed to focus investors on the “hot” areas of the market and encourage additional investments and trading which is how the trading platforms make money. 

The problem is that many of the investors using these online leaderboards to determine their trading strategy do not realize that there may be little fundamental analysis being done on the company which could cause the stock price to trade well above or well below the intrinsic value (value based on all of the facts and circumstances). Often the trends reverse fairly quickly which can cause those investors who are late to the party to incur large losses.

Small investors have also been somewhat effective at targeting large investment firms that are attempting to profit from a decline in a stock price (called shorting an investment). When a large number of investors expect a stock price to fall and it instead rises it can force these investors to buy the stock to offset their existing positions and limit their losses (called a short squeeze). In some cases, small investors have targeted stocks with a large, short interest (a large number of investors believing the price will fall). If enough of these small investors buy the stock and push the price up it can cause more investors to follow and may eventually force the large investors who are betting against the stock to buy to limit their losses. This can cause a flood of buyers with very few sellers at a given moment in time often resulting in a sharp increase in the stock price. However, as with the other strategies, this increase is often short lived as sellers move in to take short-term profits from the increase in the stock price.

When a stock price rises sharply it may look like an easy way to get rich quick. However, these movements are difficult to predict, are often short lived, and can lead to big losses for investors who are late to the party. Therefore, it is important to be very careful when investing based on short-term trends especially when prices are completely out of line with company fundamentals and long-term prudent investment standards.

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