Volumes in Trading – Risk of Trading in Low Liquidity Stocks
Any stock that trades at fewer than 10,000 shares a day is considered a low-volume stock. While there are tons of market ratios and factors for investor to consider when investing in stocks to avoid risk and maximize profit, one factor that makes any stock riskier than it needs to be is investing in stocks that trade at low volumes.
Investing in low volume stocks can put an investor’s portfolio at unnecessary risk for a number of reasons.
The major risk associated with low-volume stocks is their lack of liquidity. And liquidity which is the simple ability for a stock to be traded easily in the market without a change in price is an essential element in stock trading.
Low-volume stocks are usually harder to sell quickly and at the market/desired price. In addition to liquidity risk, low-volume stocks have several other challenges that include:
- Issues With Price Discovery
Low trading volume is often indicative of few interests from market participants, who can then command a premium for the trading of such stocks. As a result, these stocks may show a high unrealized profit than is practicable.
More so, selling low volume shares could may require flooding the market with a large supply of the stock which will cause prices to fall considerably especially if the demand remains at its consistent low level. Frequent traders often lose money when liquidity is low.
- Could Signal Poor Company Reputation
Low trading volumes are increasingly common in low-priced stocks and microcap companies, although they can also be observed across stocks belonging to all price segments.
A lot of these companies trade on OTC markets with a low requirement on business transparency. Low trading volumes may be a clear indication of deteriorating company reputation which will further affect the stock return potential.
It could be indicative that a company is new, without proven track records and yet to prove its worth.
- The Bottom Line
The reality is that low-volume stocks are usually not trading for a very good reason—few people want them. Their lack of liquidity makes them hard to sell even if the stock appreciates. They are also susceptible to price manipulation and attractive to scammers.
Traders and investors should exercise caution and perform due diligence before purchasing low-volume stocks.
- Uncertainty about the Larger Picture
There can may be unanswered questions surrounding the low trading volume of a given stock such as the possible reason for the lack of interest or wider audience for trading such stock.
The possibility of lack of transparency about company management, facts, products, services, and finances as the driver for the low volume as well as the possibility of the company’s involvement in irregularities or regulations violations.
Getting answers to all possible reasons for the trading of low volumes of a given stock provides the larger picture necessary to 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.
- Manipulative Market Makers
Market makers active in low-volume stocks can use low liquidity to profit. They are aware that the stock’s low liquidity means they can take advantage of buyers who are eager to get in and out of the market.
For example, a market maker might place a bid for 100 shares near the last sale price and a bid for 1,000 at 10% below that price. If someone naively attempts to sell 1,000 shares at the market price, then they might only get what they expected for the first 100 and get 10% less for the rest. It is necessary to use limit orders for low-volume stocks if you want to avoid these losses.
In conclusion, 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—very few people want them.
Again, their lack of liquidity makes them hard to sell in spite of the promise of future appreciation.