So far, 2021 has been a strong year for the stock market. But it has been an especially wild ride for GameStop (GME -2.38%). The stock is up 685% so far this year, a jaw-dropping rally that has investors at the edge of their seats.
While these explosive gains have the potential to make some investors rich overnight, the GameStop saga should serve as a cautionary tale. And there are a few lessons investors can learn from this extraordinary event.
1. A soaring stock price isn't always a good thing
When you're looking for stocks to buy, you generally want to focus on stocks that are on the up-and-up. A steadily increasing stock price is a good sign that a company is growing. But when a company's stock price skyrockets over a matter of days, that's a signal that something fishy is going on.
So what's actually happening here? GameStop has historically been a heavily shorted stock. When investors "short" a stock, that essentially means they're betting the stock price will go down. Recently, a group of investors in the online community Reddit began promoting GameStop stock. The more people invested in this stock, the higher its price climbed.
In addition, when short-sellers saw the price skyrocketing, many of them panicked and closed their positions. This is called a "short squeeze," and it helped GameStop's stock price climb even higher.
This makes GameStop not only a volatile stock, but a dangerous one. Its stock price has been artificially inflated so that a relatively small group of investors can make large sums of money. For the average investor looking to buy and hold a stock for the long term, GameStop's soaring stock price should be a huge flashing warning signal.
2. Short-selling can be incredibly risky
Because GameStop's stock is far higher than it should be, it's almost certainly just a matter of time before it comes crashing down. For that reason, many investors are now looking to short the stock, betting that its price will fall.
When you short a stock, you borrow shares from a brokerage and then sell them immediately. Because the shares are borrowed, you have to repay them at some point. If the stock price falls, you can buy the shares back at a lower price, return them to the brokerage, and make a profit.
However, short-selling can be incredibly risky. When you invest normally, you experience limited risk and unlimited potential gains. If you buy a share of stock for $100, you can't lose more than $100. But you can earn an unlimited amount of money depending on how high the stock price climbs.
With short-selling, it's the opposite: You experience limited potential gains but unlimited risk. Say you borrow a share of stock from a brokerage and sell it for $100. Best case scenario, the stock price drops to $0, and you make $100 profit. But if the stock price jumps to $400, you'll have to buy back the stock for that price and come up with the $300 difference out of your own pocket.
GameStop's incredible rise has pummeled short-sellers. The higher the stock price climbs, the more money short-sellers stand to lose. Even though the stock is bound to fall sooner or later, trying to time that downturn can be a risky -- and expensive -- move.
3. Do your research before investing in a stock
A company's stock price is only one part of the equation when deciding where to invest. In the case of GameStop, the price doesn't match the company's overall financial situation. The organization has been struggling for years, and just last month it announced it was planning to close 1,000 stores by the end of its fiscal year.
Although GameStop did experience a boost when activist investor Ryan Cohen made a significant investment in the company recently, investors still need to look at the big picture. When a company is struggling financially and all of a sudden its stock price skyrockets, that's a red flag.
Where to invest instead
For most investors, it's wise to stay far away from GameStop right now. Instead, it's much better to look for companies that have far better prospects to succeed over the long run.
Be sure to look at a company's overall financial health, rather than just its stock price. An organization that has experienced consistent growth over many years is a safer bet than a company with a rising stock price but a sketchy track record.
Also, try to avoid getting caught up in short-term trends. Day traders and short-term investors are trying to make money over a matter of hours or days, while long-term investors make money over the course of years. Long-term investing is a safer strategy, so it's wise to focus on high-quality companies with a proven track record and a bright future.