Be Cautious With Low Trading Liquidity Stocks
Trading Liquidity refers to the ease with which you can buy or sell a stock at or near the current market price.
Highly liquid stocks have two features. 1. Many shares, totaling a significant dollar amount trade each day. 2. A significant number of shares can be bought or sold at any given time without driving the price up or down.
A highly liquid stock has a narrow “bid-ask spread”. For example if the current bid price on a liquid stock is $10.00 then the asking price (the lowest price at which a seller will sell) may be $10.05 or $10.10. If the stock is illiquid, then the offer price could be $10.50 or more.
If a stock is very liquid then you can sell it at any time for the market offered price, which will almost always be very close to the last price at which the stock traded.
For an illiquid stock, the concept of a market price has much less meaning. If a illiquid stock last traded a few shares at $1.20, that does not mean that you could sell 10,000 shares for anything close to that price. If the shares are illiquid, there may be no offers to buy at anything close to $1.20.
While holding an liquid stock, you will typically experience great volatility in value. It may not be unusual for the trading price to fluctuate by 20% or more on a daily basis. And you may not be able to sell your holding without driving the market significantly lower.
Illiquid stocks are highly unsuitable for quick trading strategies. You should only buy such a stock if you are comfortable with holding it for several years.
All trades of illiquid stocks require caution. Orders to buy or sell at the market should never be used. Rather, limit orders should be used. Patience will usually be rewarded with a lower purchase or a higher selling price.
The liquidity of a stock can be judged by, the daily trading volume, the current bid-ask spread and by the depth of the market.
The depth of the market shows how many shares are bid to be purchased at different prices. For example there may be 200 shares bid to purchase at $1.20, 1000 shares wanted at $1.10 and 5000 shares wanted at $0.50. This would indicate illiquidity if you sell at the market, you would get $1.20 for the first 200 shares and $1.10 for the next 1000 but only $0.50 for any additional shares. And this scenario is realistic for a highly illiquid share. Similarly, there may be 200 shares offered for sale at $1.30, 1000 at $1.40 and 5000 at $2.00. In this case the buyers and sellers are far apart and we would expect few trades. However, an inexperienced buyer or seller who enters a large order to by or sell at the market could “get burned” by this lack of liquidity. Unfortunately, depth of the market of second level quotes are not available to retail investors.
Shawn Allen, InvestorsFriend Inc.
December 21, 2002 (edited April 9, 2005)