over 2 years ago • 5 mins
Most investors lost money back in January when cinema chain AMC Entertainment’s share price followed retailer GameStop’s in rising – and then falling – dramatically. On Wednesday, however, AMC’s stock soared higher than ever – and you may well be wondering whether things could be different this time.
Retail investor-driven “short squeezes” are back in the news: GameStop’s shares are trading close to their January highs, while AMC’s are three times higher. For most of us, it probably makes sense to steer clear of these highly speculative plays – but if you do want to get involved, make sure you’ve got a solid plan in place.
Here’s one such framework you could use, using AMC’s stock as a case study.
Back in January, I highlighted the three factors needed for massive stock short squeezes to happen:
A high “short float” and low trading volume
The existence of a fundamental bull thesis
Strong and rising interest from retail investors
AMC currently ticks all three boxes. It has a high short float (22.7%, according to Finviz.com) and relatively low average trading volume. The cash the company just raised from selling some of its stock to hedge fund Mudrick Capital Management could be used to expand and profit from the recovery, And AMC’s stock is once again drawing an army of devotees on r/wallstreetbets and other retail chat platforms.
The next step involves identifying how much money you’re willing to lose on your trade – bearing in mind that the later you are to the party, the more likely it is that you’ll lose it all. For the sake of our example, let’s say you’re willing to risk $100.
Successfully riding a speculative bubble requires letting your profits run, cutting your losses short, and leaving your emotions out of the process. And one tool that can deliver all three is a trailing stop-loss order.
A trailing stop-loss is initially set up just like a normal stop-loss, set at a certain dollar amount (or, even better, a percentage) below the investment’s current market price. When this article was originally written, AMC was trading at $32. If you buy a share at that price and put in a stop-loss at $22, it means you’ll sell straight away if the price reaches $22, limiting your maximum loss to $10.
Unlike a traditional stop-loss, however, a trailing stop-loss is dynamic: it’s revised up if prices rise, but – crucially – always remains unchanged if prices fall. So if the price of AMC goes down from $32 to $30, the stop remains unchanged at $22. But if the stock rises to $35, you’ll move your trailing stop-loss up to $25.
In other words, you’ll only exit the trade if the stock price falls $10 below the highest price reached since you bought. In the worst-case scenario, the price will fall immediately and you’ll lose $10 – but if the price rises after you buy in, you’ll lose less by resetting your stop higher. Better still, if the price goes up $10 in our example, then you can’t lose. The payoff profile is thus very similar to a call option: your maximum loss is limited, but your maximum gain is unlimited. Exactly what’s needed to trade such a speculative bubble.
There’s an important practical point to mention here, though: if markets move really fast, it’s possible that you won’t be able to execute your stop-loss at precisely your specified level. You should therefore add a safety margin: if you set a trailing stop-loss equivalent to $10, you should in reality prepare to lose up to $15.
If you’re risking $15 for each share you buy, and you’re willing to lose $100 on your trade, you can use this formula to calculate the number of shares you should buy in the first place:
In our example: $100 / $15 = 6.7 shares. Rounding this down (for extra safety) gives you 6 shares.
While some platforms allow you to set up automatic trailing stop-losses, not all do. You may have to set it up manually – in which case make sure you always have your stop in place and are adjusting it periodically. And when the price drops below your stop, always sell.
The main drawback of this approach is its sensitivity to where exactly you set up the stop relative to the stock’s price. Too far below, and you’ll give up a large portion of your gains should prices revert. Too tight, and you risk prices hitting your stop-loss before resuming their rise. More experienced traders might want to combine multiple wide and tight stop-losses – at any rate, selecting the right parameters is more art than science and requires some practice.
The approach is also not without its risks – the biggest being execution, whether it’s failing to update your stop-loss order or not being able to quickly exit a position. That’s why playing a speculative bubble is really for experienced investors only – and if you do try your hand at it, remember to only risk what you can afford to lose.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.