Trading in low-volume stocks can be very risky. However, where there great risk, there can also be great rewards. In this article, we will discuss strategies for trading in low-volume stocks and possibly making a profit.
Low-volume stocks typically have an daily average trading volume of 1,000 shares or fewer. They may belong to small, little-known companies trading on the OTC stock exchanges, but can also be traded on major stock exchanges. Such stocks remain outside of purview of the mainstream traders and investors and lack the general trading interest. These stocks can be risky because their low volume leads to 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.
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 does not take much to drastically change the price of the stock. However, 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. (Read more 4 Stocks With Low Volume and High Returns)
Beyond deciding on a short-term or long-term approach, also consider these seven factors when venturing into low-volume stocks:
- Individual Profile: In a thinly traded stock where there are few or no marketmakers, consider assuming the marketmaker role. A marketmaker selects one (or two) stocks and offers buying and selling on these stocks by quoting bid and ask price. He 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. However, be sure to have a backup plan. 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) and many such companies were once lesser-known stocks trading 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 multibaggers. 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: Some stocks may trade at low volumes due to their very high stock price (say above $500 a share). Berkshire Hathaway, Inc.’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. Similarly, Seaboard Corp. (SEB) trades at $3,750 per share with an average daily volume of only 470 shares. In such stocks, a corporate action, for example 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 high interest rates and inflation. Such periods often see overall low stock trading activity. Stocks that were thinly traded before the recession fare even worse. But recessions and slowdowns almost always abate or reverse 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 the doomsday saw their low-priced purchases triple in under 4 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." Overall market rise may be a result of stable government, easing oil prices, and other local or global developments. In cases of such overall market rise, low-volume stocks often stand to benefit the most.
- Potential benefit from exchange-driven changes: Bloomberg.com recently covered a proposal by Bats Global Market Inc., one of the biggest U.S. stock exchanges, to concentrate low-volume stocks on fewer exchanges, thus possibly increasing their liquidity. “An exchange could increase volume by holding midday auctions, changing the price increments or amending market-maker standards,” writes Bloomberg of the Bats Global plan. Such 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.
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 take a long-term perspective—invest with excess money that you may not need and select stocks which have good business potential.