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Clover Health takes off: 3 things to think about before buying the next big meme stock

"If the thought of losing a couple hundred bucks is anathema to you, maybe you shouldn't be in these."

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So-called "meme stock" traders took a break from pumping up AMC Entertainment on Tuesday to pile into shares of Medicare insurance start-up Clover Health, which was up by more than 100% at one point. The stock ended the day up 86%, after logging a 32% gain the day before.

As happened earlier this year with AMC and GameStop, professional traders have been betting that Clover stock is headed down. Retail meme-stock traders, meanwhile, many of whom share strategies on the Reddit forum WallStreetBets, are hoping to take advantage of bets against the stock from Wall Street pros. By pumping up the price, they trigger what's known as a "short squeeze" — a move in which institutional investors betting against the stock are forced to start buying shares as it appreciates in order to mitigate their own losses.

As a result, shares of the shorted stocks shoot up even higher, boosting the value of retail traders' portfolios, at least over the short term, and sticking it to Wall Street honchos in the process.

The shares cooled off on Wednesday morning as many traders on Reddit seemingly moved on to other targets.

Curious about the next stock retail traders will send to the moon? Thinking of joining that frenzy? Here are three things to consider first.

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You could be buying at the top

If you're buying into a stock after it's already gotten a ton of buzz, you run the risk that you could get in just in time for a pullback. Consider a recent study published by the Social Science Research Network entitled "Attention Induced Trading and Returns: Evidence from Robinhood Users." In it, a group of finance professors found that from May 2, 2018, to August 13, 2020, stocks that got the most attention from Robinhood users on any given day were likely to experience price drops over the subsequent month, with the most extreme "herding events" among retail investors leading to average declines of roughly 9%.

The conclusion: "Large increases in Robinhood users are often accompanied by large price spikes and are followed by reliably negative returns."

The study falls in line with two decades of academic studies showing that day-trading individual stocks is by and large a losing proposition for retail investors, and even professional traders.

Size your bet properly

Meme stocks have experienced large runups due almost entirely to investor speculation, rather than more traditional reasons for stock market runs, such as improving earnings or cash flows, says Sam Stovall, managing director of U.S. equity strategy.

Because of that, he notes, these investments are volatile, and it isn't wise for investors to gamble on them with significant portions of their portfolios. "Basically, you should be thinking, 'What can I afford to lose?'" he says. "That's going to be based on the size of your portfolio and your ability to sleep at night if you're losing money. If the thought of losing a couple hundred bucks is anathema to you, maybe you shouldn't be in these at all."

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Before buying, know your goal: 'Look inward'

As with any investment, it's important to examine your reason for buying a meme stock before adding it to your portfolio. "Investors need to look inward," Stovall says. "Ask yourself, 'Am I investing for the long term or the short term?' Meme stocks are only going to be a very short-term investment."

If you're investing for retirement, it may not be worth taking your eyes off the prize to dabble in short-term gains.

On the other hand, if you are willing and able to use a small portion of your assets to gamble on a meme stock, be sure you have an exit strategy, says JJ Kinahan, chief market strategist at TD Ameritrade. That means identifying the price at which you'd sell — whether the stock goes up or down — before you buy, he recently told CNBC. "It's not an all-or-none game."

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