The Rewards of Trading Stocks With Low Volume

Trading in low-volume stocks can be very risky. Low-volume stocks typically have a daily average trading volume of 1,000 shares or fewer. They may belong to small, little-known companies that trade over-the-counter (OTC). But they can also be traded on major stock exchanges.

These kinds of stocks remain outside of the purview of the mainstream traders and investors and lack the general trading interest. They can be risky because their low volume leads to a lack of liquidity and ease in price manipulation. Smaller and newer companies are also disproportionately represented in low-volume stocks. Such companies can simply go belly up and leave investors with nothing.

But there may be great rewards in the same place you find great risks. In this article, we discuss strategies for trading in low-volume stocks and possibly making a profit.

What's Your Approach?

Before venturing into low-volume stocks, decide on an approach. Are you in it for short-term trading gains or are you investing long-term in a little-known company that you believe in? Short-term traders can quickly reap profits from the sporadic price movements of low-volume stocks.

Because so few shares are usually traded, it doesn't take much to drastically change the price of the stock. But there is always a risk that you cannot buy or sell the stock for maximum profit due to the stock’s lack of liquidity.

Long-term investors in low-volume stocks should be adept at assessing a company’s business prospects. Research such stocks well and understand the company before making the investment. Experienced traders know that many little-known companies frequently list on OTC stock exchanges to raise money, but only a few succeed in the long run.

Beyond deciding on a short-term or long-term approach, you may also want to consider some other factors when venturing into low-volume stocks. We've listed seven below.

Individual Profile

Consider assuming the market-maker role with thinly traded stocks where there are few or none at all. Remember that a market-maker selects one (or two) stocks and offers to buy and sell them by quoting bid and ask price. As such, this individual facilitates both buying and selling to maintain liquidity.

In this role, the trader can take advantage of low liquidity by offering wide bid-ask spreads to the trading counterparts and pocketing the difference. But be sure to have a backup plan. And take a more limited position rather than piling up huge inventory that you may not be able to offload.

Multibagger Potential

Microsoft (MSFT), Infosys (INFY) may be huge names today. But at one point, their stocks weren't that well-known and traded at very low volumes. Investors who managed to pick them young either through luck or robust stock analysis were able to multiply their investments many times. In other words, they picked what some in the financial industry call multibaggers.

The term multibagger refers to a company whose stock increases in value multiple times over from its original value (the bag). So someone whose original investment of $1,000 multiplied to $10,000 has a 10-bagger.

For investors who understand an industry well and do their research, long-term windfall gains are a distinct possibility in low-volume stocks.

Benefits From Corporate Actions

Not all stocks have a low trading volume because of their popularity. In fact, some stocks may trade this way because of their very high stock price. For instance, Berkshire Hathaway’s Class A stocks (BRK-A) trade at the astounding price of $214,675 per share. The average trading volume is only 320 shares per day. Seaboard (SEB) trades at $3,750 per share with an average daily volume of only 470 shares.

With stocks like these, a corporate action like a stock split can lead to lower prices and higher trading volumes. The result is increased liquidity and higher market participation where returns can be substantial. The challenge remains predicting when corporate actions will occur.

Macroeconomic Factors

Low-volume stock trading can also be a result of local or global macroeconomic factors. A country may be going through a slowdown or recession with higher interest rates and inflation. Such periods often see overall low stock trading activity. Stocks that were thinly traded before the recession fare even worse.

Recessions and slowdowns almost always abate or reverse if they're given enough time. Experienced investors can use excess capital to invest in cherry-picked winners that will perform with high returns in the long run.

Temporary Events and Phases

The uncertainty around major events such as political upsets, strife, or extreme weather can be an opportunity to benefit from low-volume stocks. In 2004, India’s general election results were accompanied by a major drop in stock prices when a coalition backed by Communist parties was the only available option for government formation.

Investors who picked up stocks on doomsday saw their low-priced purchases triple in under four years. A few of the best performers were little-known, low-volume stocks that saw up to 15-fold returns.

Benefit From Overall Market Rise

As the saying goes, "when markets rise, everyone makes money." The overall market rise may be a result of stable government, easing oil prices, and other local or global developments. In cases of such an overall market rise, low-volume stocks often stand to benefit the most.

Exchange-Driven Changes

Exchange-imposed changes or initiatives have the potential to shoot up the returns from thinly traded stocks, offering substantial profit opportunities to risk-favoring investors. For instance, Bats Global Market, one of the largest stock exchanges in the United States, put forth a proposal to concentrate low-volume stocks on fewer exchanges. A move like this could possibly increase the liquidity of these low-volume stocks.

The Bottom Line

Trading low-volume stocks is a risky game. Potential benefits are subject to many factors outside the investor’s control. The best bet for an investor is to take a long-term perspective—invest with excess money that you may not need and select stocks that have good business potential.