Amid thousands of stocks trading on world markets, a substantial percentage is very thinly traded, i.e. stocks which irregularly trade at low volumes. Investors should be aware that these low-volume stocks pose considerable trade risks.
One risk of low volume stocks is the lack of liquidity, which is a significant criterion in stock trading. Liquidity is the ability to easily be purchased or sold on the market without a price change. So a stock trading at $25 per share should be bought or sold easily in high amounts (say 100,000 shares) while still keeping the price of $25 per share.
For stocks, the average daily trading volume is a good measure of liquidity. In general, every stock trading on less than 10,000 shares a day is considered to be a small stock. Low volume inventories are more difficult to buy or sell quickly and at market prices. They are present in every segment, including large, mid, small, micro and nano cap inventories and in various price ranges from high-price bands to penny inventories (say $300 or more). Apart from liquidity risks, low volume stocks present six challenges:
Fair Price Discovery Challenges
The absence of volumes of trade indicates the interest of just a handful of market participants, who can subsequently order a premium to trad such stocks. Even if you have unrealized profits on such an stock, the profits can not be realistically realized. Suppose you bought 10,000 shares of the company a year ago at a price of $10 per share and trading now at US$ 13 per share. So you’re sitting on unrealized profit of 30 percent. You want to sell 10,000 shares and pocket the profit. If the average trading volume for this stock is only 100 shares a day, it may take time (perhaps days) for you to sell 10,000 shares. The act of selling your shares may also affect low-volume stock prices. Flooding the market with a significant stock supply (essentially 100 times the average daily) will cause prices to drop substantially if demand continues to be low.
Price Manipulation Possibility
Market manufacturers active in low-volume stocks can benefit from low liquidity. They are aware that the low liquidity of the stock means that they can benefit from large tenders. The offer is the highest price a buyer is prepared to pay, while the request is the lowest price a seller is prepared to accept. A high volume share will be tightly distributed (say 10,20 dollars / share bid rate and 10,30 dollars / share bid price making it 0,10 dollars / share). A small stock could be broadly spread (e.g. $9.80 per share bid price and $10.60 per share ask price making it $0.80 per share).
Deteriorating company reputation
While there is low volume of trading in all stocks of all price segments, this is particularly common in microcap companies and inventories with low prices. Many of these companies trade on OTC markets that do not require business transparency. Such enterprises are often new and lack proven track records. Low trading volumes can clearly indicate a deteriorating reputation of the company, which will further impact on stock return potential. It could also be an indication of a relatively new company still worth proving.
Unsure about the bigger picture
What are the real reasons behind the stock’s low trading volume? Why is there no interest in trading this stock or a wider audience? Are there any reasons for not being transparent about the management, information, products, services and finances of enterprises? Is the company involved in certain irregularities that may include infringements of rules? Answers to all these questions can give a wider picture that drives the stock’s future return potential. Any possible reasons on the other hand will affect the future trading of the stock of the company.
The susceptibility of promoters to malpractice
Low volumes of trading often lead to temporary (artificially inflated) price increases in which developers are able to discharge their large shareholdings to shared (and often unaware) investors with high prices and leave them with potential long-term losses. Unreliable brokers and salesmen find such low volume stocks a good way to make cold calls claiming to have information on the next so-called ten-bagger (a stock that multiplies 10 times the value).
Vulnerability to marketing misconduct
Other practices involve issuing fraudulent media reports with high prospects for return. Many common investors can be subjected to these practices.
In summary, as tenting as it might be to stumble over a low volume and think it’s a rough diamond, the fact is that smaller stocks usually don’t trade for a very good reason, and that’s why few want them. Their liquidity failure makes them difficult to sell even if the stock is appreciative, price manipulation susceptible and scammers attractive. Traders and investors should be cautious and diligent before buying low volume stocks.