Courtesy of Charles Rotblut, CFA , who is the VP and Editor for American Association of Individual Investors (AAII).

Like many others, I’ve been watching shares of GameStop Corp. (GME) with a bit of disbelief. For those of you who have not seen the headlines, the stock’s price soared from a closing price of $19.95 on January 12 to an intraday high of $482.85 earlier on January 28.

The chart on the right shows the price action. It’s a three-month chart. I could have used a six-month, one-year, three-year or five-year chart. None would have looked drastically different because of the magnitude of the recent surge. GameStop has taken off like a rocket after years of trading below $25 per share.

GameStop is a good example of a lottery stock. The term is used to describe highly risky stocks with a small chance of a big return. As the name implies, there is a big element of luck involved in hoping to realize a gain on them. The video game retailer’s revenues and net income have been on a downward trend for several years. This is why GameStop has an A+ Investor Growth Grade of D. The company’s business model is facing the existential threat of a growing number of digital downloads of games. (The base version of Sony’s new PlayStation 5 console only takes digital downloads, no discs.)

Despite this threat, shares of GameStop have jumped due to a combination of herd mentality and speculation. A stock-trading group on social media platform Reddit is being particularly singled out by the media for driving this mania. Posters encouraged each other to keep trading and making bold predictions of where the stock is heading. It can be very hard not to act when others are claiming to make money, and the stocks they are talking about are making huge gains over a short period of time. The fear of missing out (FOMO) frequently crowds out a person’s ability to stop and ask objective questions. These questions include (but are certainly not limited to): “If most people think they’ll know when to sell, what gives me the confidence to think I’ll know the right time to sell before they do?”

FOMO strikes when big gains occur. We remember the big upward moves we missed out on. What we don’t remember—and frequently don’t pay as much attention to—are the big losses we avoided. For every stock that has been able to hold onto a big gain, there are countless others that have plunged in price.

Beyond being cautious of FOMO, it’s important to be careful about what information you act on. There is no requirement on Reddit for others to tell the truth about their portfolio returns. Blindly taking tips from strangers you know very little—if anything—about is never a good investment strategy. Always do your own research by looking at credible sources.

There is also the role of luck to consider. Huge speculative gains realized over a short period of time are rarely attributable to skill. Luck—both good and bad—constantly plays a role in investing; knowing when returns are attributable to luck and when skill played a role will serve you well. Those who got in and out of GameStop with sizeable profits benefited from a bout of good luck.

Hedge fund Melvin Capital and investment firm Citron Research as well as others who had taken a bearish position on GameStop were hit with a large bout of bad luck on risky bets. The losses incurred by Melvin Capital are unknown. The Wall Street Journal says two other firms agreed to immediately invest $2.75 billion into Melvin Capital’s fund. The infusion is believed to help Melvin avoid margin calls. (A margin call is a requirement by a broker to put up more collateral. It happens when securities purchased with borrowed money, meaning by using margin, fall in value by a large enough magnitude.) What we do know is that the losses show the danger of shorting a stock and of selling uncovered (“naked”) options.

In simplistic terms, shorting a stock involves selling shares you don’t own. The short-seller then hopes to purchase the stock at a lower price to complete the transaction. Think of it as the opposite of buying a stock and then selling it. Since the price of stock can only fall to $0, the upside is limited. The maximum gain is the price the stock was sold at minus the price paid to close out the short sale. The maximum loss, however, is unlimited since a stock can technically keep rising in price. Someone who sold GameStop short when it was trading about $19 had a liability in excess of $460 per share this morning if they hadn’t previously closed their short position—a massive loss.

Selling uncovered call options has a similar risk/reward profile. A call option gives the buyer of the contract the right to purchase the stock at a set (“strike”) price. The seller is obligated to sell the stock at the strike price if the call option is exercised. The upside for the seller, if the stock doesn’t rise in price, is the premium received from selling the option contract. If the stock rises above the call price, the buyer can exercise the contract at the specified strike price. The seller of a naked call contract with a $20 strike price in GME could have technically been forced to buy shares of GameStop for as much as $482 per share to cover the options contract. Again, a massive loss.

While GameStop’s huge gains and volatility are surprising, the behavioral biases driving them is a case of history repeating. Manias within the financial markets have been documented ever since the Dutch tulip bubble nearly 400 years ago. It’s going to happen again. The human brain has yet to evolve enough to cope with the financial markets. Greed, FOMO, herd mentality and a sizeable list of other cognitive biases interfere with our collective ability to make rational decisions on a consistent basis. This is why we at AAII suggest that individual investors follow a disciplined, systematic, evidence-based approach to investing. It’s your best defense against the speculative desires that often lead to large losses.