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One of the biggest stock market stories in the past year has been the growth of social media trading. This phenomenon is called a variety of names such as 'meme trading,' 'Reddit trading,' and WallStreetBets, but it is simply a group of small, aggressive traders that help to create big moves in selected stocks.

The business media likes to portray this as something new, but this sort of trading has been part of markets from their very beginning hundreds of years ago. There will also be groups that question the conventional wisdom of the professionals that control the market. It is no surprise at all that there are small traders with limited capital who have no interest in the idea that they should hold a diversified portfolio of stocks for the long term.

The recent surge in social media trading was caused by a perfect storm of circumstances. The pandemic created a combination of more free time, a need for entertainment, free cash payment, and better social networking. Trading hot stocks was a great way to spend some time, and brokers like Robinhood made it extremely easy to trade small accounts money. There isn't even commissions or transaction costs to create friction and slow things down.

The lack of transaction costs, the ability to trade extremely small amounts of money, and the better organization of social media are what are empowering the trend. One other big difference is that there is a very clear intent that much of the trading is done to manipulate stocks higher, either by squeezing shorts or orchestrating sustained buying.

While there is often some discussion about the fundamentals and long-term prospects of a stock like GameStop (GME) or AMC (AMC) , that is not what is driving the short-term action. Having a bullish narrative is a good cover for trying to catch institutional Wall Street in the wrong position.

Social media is going to exist in various forms as long as there are markets. This is not some new idea that is going to create a steady flow of easy profits. It is a cutthroat business, and if you want to make money trading these stocks you must recognize that other traders are your competitors and not your friends.

The essence of social media trading is to catch a strong move and then exit in a timely way to lock in profits. Some folks on social media have created this idea that it is a political movement of some sort, and if they all work together and hold stocks with 'diamond hands,' then they will conquer evil hedge funds and clueless institutions.

It may be a laudable sentiment, but social media traders that buy into the 'diamond hands' argument will be the ultimate bag holders. You can be quite sure that the folks that are orchestrating some of the action in targeted stocks are taking some profits into strength. If they aren't, then there are thousands of other traders that are.

It is important to recognize that this isn't just small individual traders versus big hedge funds and rich traders. The hedge funds and rich traders are helping to create the big moves in stocks like GME. It isn't just the little guys that are causing billion-dollar moves in social media stocks. It is big, aggressive money, and they don't care one bit about your diamond hands. A couple of big winners will suck people into dozens of bad trades.

I've been engaged in social media trading in various forms for the last 25 years. We see very similar action during the internet bubble in 1999-2000 when small trades would swap stock picks in social settings. Eventually, most of those traders disappeared, and it took years for some to ever trade again. Hopefully, that won't happen to the same extent this time, but we have already lost quite a few amateur traders that were caught at the top in speculative stocks that started in February

Here are some things to watch out for:

- Most of the folks that promote social media trades will spend substantial time bragging about their great success. If you hear talk about exotic cars, you can be sure that a form of social media trading is taking place. They want to create the impression that this sort of trading is simple and easy, and you just have to buy the right stock and hold on to it. There is very little focus on trading tactics. The message is to buy and keep buying. It is pretty easy to understand what is going on there.

- Learn how to pick your own stocks. Social media trading is surprisingly uncreative in finding new stock ideas. They stick with certain names because they are already heavily invested in them financially and emotionally.

- The people on the other side of the trades are not idiots, and they have more money than you do. Put yourself in the shoes of the person on the other side of your trades. What are they thinking when you are buying and vice versa. What is their strategy?

- What social media does best is create higher levels of volatility. Trading volatility is why social media trading is so appealing. The idea may stink and have lousy justifications, but when thousands of traders are focused on a particular stock, then it is going to move, and that is the opportunity that can be exploited.

- This is a zero-sum game. If you are making money, then someone else is losing it or not making it. Other traders are looking to take your cash

Social media trading is fun and can be profitable, but if you want to be a 'real' trader, then you have to educate yourself and lose the gambling mentality that social media trading promotes. The most important issue for professional traders that do this for years is the preservation of capital. You protect capital so you can stay in the game and trade the next opportunity. The YOLO trade is the dumbest thing you can do if you want to be a professional trader. You have to always manage risk. Good traders grind out profits steadily for many years.

The media stories about meme trading are entertaining, but it is just another opportunity in a sea of ideas. Rather than embrace social media trading, look for ways to exploit the price movement that it creates.

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Excerpt from:
Exploit Meme Trading for Fun and Profits - RealMoney