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In this article, we’re going to talk about securities that have very low or almost no liquidity and what challenges they pose for investors when making investment decisions.
Understanding the characteristics of thinly traded securities
Thinly traded securities are financial instruments, such as stocks, bonds, or derivatives, that have low trading volume and limited market activity. This can be due to a variety of factors:
Market cap and stock price
Low market capitalization (total market value of outstanding shares) often translates to lower liquidity.
Companies with a smaller market cap, typically younger or less established firms, have a limited number of shares outstanding. This translates to fewer shares being traded daily, leading to lower trade volume and wider bid-ask spreads.
Note: The difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
Company visibility and the float
Companies with a lower public profile or limited public ownership also tend to have lower liquidity in the markets.
Note: Floating stock is the number of shares (out of the total outstanding) the company has ‘floated’ for public trading. The rest of these stocks are either tied up in early stage financing deals, ESOPs, RSUs, etc.
Low public float could also be due to factors like a recent initial public offering (IPO) with a large portion of shares held by institutional investors, or a company operating in a niche industry with a smaller investor base.
Volatility and border market conditions
Highly volatile stocks, with significant price fluctuations, can experience periods of lower liquidity. Investors may be hesitant to enter or exit positions due to uncertainty, leading to lower trading volume and wider bid-ask spreads.
Additionally, broader market downturns can lead to reduced investor participation across the board, impacting liquidity even for typically liquid stocks.
The exchange and the platform for trading
Stocks listed on smaller or less active exchanges generally have lower liquidity compared to those listed on major exchanges like the NSE or BSE. Similarly, stocks traded on less popular trading platforms may have fewer interested buyers and sellers, impacting their liquidity.
How to trade in thinly traded securities
There are some things that you have to do differently to trade in securities that are not that liquid. Here are some tips:
- Have patience: Illiquid stocks may not offer the same level of immediate buying and selling opportunities compared to highly liquid stocks. When considering holding these shares, you must have a long-term horizon and the ability to hold these investments for an extended period of time. This will cancel out short-term volatility and make the company a growth or value move based on fundamentals.
- Limit orders: Market orders, which aim for immediate execution at the best available price, are not ideal for illiquid stocks. Instead, you must rely on limit orders that specify the maximum price you’re willing to pay for a buy order and vice versa.
- Fundamental analysis is king: Since readily available market information for illiquid stocks may be limited, conducting thorough fundamental analysis becomes even more critical. By analysing the company’s financials and future growth prospects, you could invest in the company for its intrinsic value, irrespective of the current market price. This gives you tremendous potential upside in the long term.
Frequently Asked Questions
There are two major ways of identifying thinly traded securities: low trading volume – which is a low average daily trading volume number, and a wide bid-ask spread – which is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).
Liquidity is a major concern with thinly traded stocks. Placing a market order is usually not ideal. Sometimes, limit orders may also slip and not get filled at the desired price. Investor caution in such cases is highly advised.
Yes, thinly traded stocks carry a higher degree of risk compared to their liquid counterparts.
With high risk comes high reward. If an illiquid company experiences positive developments, its stock price could surge due to the lower trading volume, offering significant returns.
You could try investing in small-cap mutual funds that deal in illiquid shares. Most times, these large institutions will have better mechanisms to set orders that get filled at a certain price compared to a retail investor, which will boost your returns. Alternatively, you could also invest in holding companies that in turn buy unlisted, or thinly traded companies for equity expansion.