Amid thousands of stocks actively trading in global markets, a significant percentage are very thinly traded stocks, in other words, stocks that trade irregularly at low volumes. Investors should be aware of the considerable risks of trading in these low-volume stocks.
One risk of low-volume stocks is that they lack liquidity, an important criterion in stock trading. Liquidity is the ability to be easily bought or sold in the market without a change in price. This means that a stock which is trading at $25 per share should be easily bought or sold in large amounts (say 100,000 shares) while still maintaining the price of $25 per share. For stocks, a good measure of liquidity is the average daily trading volume. In general, any stock that trades at fewer than 10,000 shares a day is considered a low-volume stock.
Low-volume stocks are harder to buy or sell quickly and at the market price. They are present in all segments including large-cap, midcap, small-cap, microcap, and nano cap stocks and also across different price bands from high-price bands (say $300 or above) to penny stocks. In addition to liquidity risk, low-volume stocks carry the following six challenges:
1) Challenges in Fair Price Discovery
Lack of trading volume indicates interest from only a few market participants, who can then command a premium for trading such stocks. Even if one is sitting on unrealized profit on such stock, it may not be possible to realize the profits realistically. Assume one year ago you purchased 10,000 shares of a company at a price of $10 per share, and now it is trading at $13 a share. Thus you are sitting on 30 percent unrealized profit. You would like to sell your 10,000 shares and pocket the profit. However, if the average trading volume of this stock is only 100 shares per day, your attempt to sell 10,000 shares will take time (perhaps days). The act of selling your shares may also affect prices in a low-volume stock. Flooding the market with a large supply of the stock (essentially 100 times the daily average) will cause prices to fall considerably if the demand remains at its consistent low level.
2) Price Manipulation Possibility
Market makers active on low-volume stocks can use low liquidity to their advantage. They are aware that the stock’s low liquidity means they can take advantage of wide bid-ask spreads. The bid is the highest price a buyer is willing to pay while the ask is the lowest price a seller is willing to accept. A high-volume stock will trade at a tight spread (say $10.2 per share bid price and $10.3 per share ask price making the spread $0.10 per share). A low-volume stock may have a wide spread ( for example a $9.8 per share bid price and a $10.6 per share ask price making the spread $0.8 per share).
3) Deteriorating Company Reputation
Although low trading volumes are observed across stocks belonging to all price segments, it is especially common in microcap companies and low-priced stocks. Many such companies trade on OTC markets which don’t require transparency about business. Often such companies are new and lack proven track records. Low trading volumes may be a clear indication of deteriorating company reputation which will further affect the stock return potential. It may also be an indication of a relatively new company that has yet to prove its worth.
4) Uncertainty about the Larger Picture
What are the real underlying reasons behind low trading volume of the stock? Why is there no interest or wider audience for trading this stock? Are there any reasons which may include lack of transparency about company management, facts, products, services, and finances? Is the company involved in some irregularities which may include violating regulations? Answers to all such questions can provide the larger picture which will drive the future return potential for the stock. Any of the potential reasons being on the other side of the rules will affect the future trading of the company stock.
5) Susceptibility to Malpractice from Promoters
Company promoters are best informed about the realistic valuations of a stock. Low trading volumes often lead to temporary periods of (artificially inflated) price spikes where promoters can offload their large shareholdings to common (and often ignorant) investors at high prices, leaving the latter with long-term loss potential.
6) Vulnerability to Marketing Misconduct
Unreliable brokers and salesmen find such low volume stocks a good tool to make cold calls with claims of having the insider information on the next so-called ten-bagger (a stock that multiplies ten times in value). Other practices involve issuing fraudulent press releases to lie about high return prospects. Many common investors can fall prey to such practices.
As tempting as it may be to stumble upon a low-volume stock and believe it is a diamond in the rough, the reality is that low-volume stocks are usually not trading for a very good reason—few people want them. Their lack of liquidity make them hard to sell even if the stock appreciates, susceptible to price manipulation, and attractive to scammers. Traders and investors should exercise caution and perform due diligence before purchasing low-volume stocks.
Shobhit Seth can be contacted at: FuturesOptionsEtc