One of the most important features of any stock is its liquidity, and it can have a direct influence on how a stock trades, its volatility, and its price. For this reason, investors need to be aware of what illiquid stocks are, how to identify them, and exactly how to trade them.
In this guide, we’ll cover all the possible questions you may have about illiquid stocks and tell you exactly how to identify them and how to buy and sell them.
What is an illiquid stock?
An illiquid stock is characterized by having a low traded volume, which means that there are only a few investors buying and selling the stock, and therefore the traded volume is low. Illiquid stocks tend to be riskier and more volatile because a few investors trading it can have a larger impact on the price.
For example, there might be only one seller and buyer for a specific stock, and the prices they set and eventually agree on can make a stock trade a lot higher or a lot lower. For this reason, it is common for illiquid stocks to move over 5% in a day without being heavily traded, and this is a common feature of penny stocks.
Main characteristics of illiquid stocks
As we mentioned, illiquid stocks tend to be more volatile because there are fewer investors buying and selling them. This leads to a higher spread between the bid and ask, which makes the price settled throughout the trading day fluctuate more. A large-cap stock is heavily traded, and therefore investors usually settle on prices within a narrow bid-ask spread, while illiquid stocks may have just a handful of buyers and sellers, which explains the wider bid-ask spread and the inevitable volatility.
While risk and volatility are not exactly the same concepts, they are related. The fact that illiquid stocks are more volatile makes them riskier to hold and trade, which eventually makes a lot of investors avoid them entirely. Illiquid stocks also can’t be traded in the same way as regular stocks, especially if you have a large portfolio, it can take weeks and sometimes months, depending on the traded volume, to open a position without pushing the price of the stock higher.
3. Avoided by institutional investors
One of the main requirements institutional investors have to invest in a stock is liquidity because this can pose a risk to the whole portfolio. If you are managing several million or even billions of dollars, you can’t build large positions on your portfolio on illiquid stocks that might not be traded. In case of redemptions, as in investors pulling out money from a fund, for example, the portfolio manager will have to sell positions to adjust its assets under management, and if a stock is illiquid, this may force the sale at a lower price, just to be able to raise liquidity.
4. Not covered by analysts
Since most stock analysts do research for institutional investors, most illiquid stocks tend to not have any coverage. This means that for most of these companies, there are no analysts creating financial models and covering the financial results of the company. While this may seem like a disadvantage of investing in illiquid stocks, it is actually an advantage for retail investors that willing to go the extra mile and research unknown and obscure companies.
5. Technical analysis
While technical analysis isn’t exactly a science and may not be very helpful to fundamental investors, traders rely on it. However, when it comes to trading illiquid stocks, technical analysis does not work the same way because the number of inventors trading these stocks is so low you can’t really make any conclusions by reading the stock chart or trying to identify trading patterns.
6. Low trading volume
As we already mentioned, illiquid stocks are thinly traded, which means that there are just a handful of shares traded every day, or the total amount traded can be extremely low. This can be enough to make some inventors shy away from these stocks.
Imagine you are managing a portfolio of $1 million, and you are trying to build a position in a stock that only trades about $5,000 each day. That can be complicated because a simple buy order can immediately affect the price, and it might even be impossible to fill the order. Additionally, you will also be pushing the price of the stock higher than you want to buy, which is counterintuitive.
7. Bid-ask spread
The difference between the highest price an investor puts an order to buy a certain stock and the lowest price an investor puts an order to sell the same stock determines the bid-ask spread. The bid-ask spread is typically narrower the higher the traded volume, and therefore, because illiquid stocks have a lower traded volume, the bid-ask spread is often very wide. This makes it difficult for investors to fill their orders.
8. Order execution
Lastly, due to the large bid-ask spread and the lower traded volumes, the order execution of illiquid stocks is not the same as highly traded stocks. This means that if you put an order for an odd lot, something that is not 100 shares, or 1,000, it can be difficult or even impossible to get that order filled. The order can also not be filled because the spread between the bid and ask is too wide, and buyers and sellers may not even agree on a price during the whole trading day.
How to know if a stock is illiquid
There are a few ways to identify illiquid stocks, and it all starts by understanding their characteristics of them and looking for them. The main two things are the traded volume that will be low, and you will also notice that the stocks do not have any or very few institutions holding the sarees. This can be easily viewed on a website like Yahoo Finance, where you can see the traded volume daily, weekly, and monthly, and also the owner of the stock.
These signs include:
- Low volume: If a stock has low trading volume daily, there is a high tendency that it will be illiquid.
- Low or high prices: If a stock regularly hits its lowest traded price or its highest, that is a sign of illiquid stock.
- Wide spreads: If a stock has a wide difference between the bid price and the ask price, it is an indication of illiquid stock.
- Low interest: If a stock has low ownership from institutional investors, it is a sign of illiquidity.
How to trade illiquid stocks
Whether you are buying or selling illiquid stocks, the key to both is to have patience and create a plan. You can’t approach trading illiquid stocks the same way you would with a large cap. You need to set up a plan based on how many shares you want to buy or sell. Then calculate the average weekly and daily volume, and try to determine how much you should be trading daily.
Once you do this, now you have to place your orders every day to avoid a large spike of volume or bid and ask size and start accumulating or dumping those shares. The main reason why you need to take this approach is that it is fairly easy to push the price of a stock higher or lower when it is illiquid, sometimes with just a simple order of 100 shares. Therefore to avoid creating volatility and make sure you get the best execution, you need to divide different buying or selling lots.
Pros of illiquid stocks
The biggest advantage of illiquid stocks is that these can be real winners. While most inventors spend time looking and researching well-known companies that every investor knows about, the fact is that making money on these names that everyone knows is difficult. When it comes to illiquid stocks, the higher volatility presents a lot of opportunities to buy the stock at attractive prices, and it can also push the price up fairly quickly. However, this requires a lot of experience and know-how.
Nobody is covering these stocks
One of the reasons why illiquid stocks can be great investments is that most inventors, both institutional and retail, as well as analysts, are not covering them. Usually, in the stock market, the price of stocks reflects all of the available information on the company, but because illiquid stocks are often obscure and forgotten, you can find situations with large mispricings between the traded price and the value of the stock. This is usually where some of the savviest value investors pick their winners.
Cons of illiquid stocks
The risks of trading illiquid stocks are not exactly the same as other stocks. If you want to liquidate positions in illiquid stocks, it can take a long time, and your order may even affect the price, so it’s usually better to consider this before starting to trade illiquid stocks.
Investors also need to be prepared for the high level of volatility, and it is not something that everyone can deal with. This adds additional risks, and it makes it more complicated to trade and invest in these types of stocks.
Trading illiquid stocks require a lot of patience and a plan. This is another disadvantage of investing in these companies, it can take a lot of time to buy and sell large positions, and you may even have to try to do an off-market deal.
Complicated to research
Because illiquid stocks do not attract the same following as large caps, it makes it difficult to research them. There isn’t as much information available, and most investors haven’t even heard of the company. Therefore it will be more time-consuming, and it may even be impossible to research illiquid stocks with the same level of detail as you would research a large company.
Should investors buy or sell illiquid stocks?
Although the liquidity of a particular stock should not be the determining factor for investors to decide whether to invest or not, it should always be considered. Broadly speaking, if you are planning on speculating in the short term, then you should avoid illiquid stocks due to the high spreads and low volumes.
This can have a particularly negative impact on the returns you expect. On the other hand, if you pretend to hold a stock for the long term, liquidity should not be your main concern. However, it is wise to keep in mind that if you ever sell the stock, you might have to do it over several days. This is to avoid moving the market with just a few orders.
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