A significant percentage of shares are very thinly traded stocks. These stocks trade irregularly or at low volumes. Investors should be aware of the considerable risks of trading in these low-volume stocks. Below, we deal with seven of the top dangers.
There is no need to invest in low-volume stocks. Most investors are better off with ETFs, mutual funds, and large listed companies.
1. Low Liquidity Makes Trading Difficult
One risk of low-volume stocks is that they lack liquidity, which is a crucial consideration for stock traders. Liquidity is the ability to quickly buy or sell a security in the market without a change in price. That means traders should be able to buy and sell a stock which is trading at $25 per share in large amounts, such as 100,000 shares, while still maintaining the price of $25 per share.
Low liquidity can also cause problems for smaller investors because it leads to a high bid-ask spread. The average daily trading volume is a good measure of liquidity. As a general rule, frequent traders often lose money when liquidity is low.
2. Challenges in Profit Taking
Lack of trading volume indicates interest from only a few market participants, who can then command a premium for trading such stocks. Even if one is sitting on unrealized gains on these stocks, it may not be possible to take the profits.
Suppose that you purchased 10,000 shares of a company at $10 per share one year ago, and then the price rose to $13. Thus, you are sitting on an unrealized profit of 30%. You would like to sell your 10,000 shares and pocket the gains. If the average daily trading volume of this stock is only 100 shares, it will take time to sell 10,000 at the market price.
The act of selling your shares may also affect prices in a low-volume stock. Flooding the market with a large supply of the stock can cause prices to fall considerably if the demand remains at a consistently low level.
3. 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.
4. Deteriorating Company Reputation
Although low trading volumes are observed across stocks belonging to all price segments, they are especially common for microcap companies and penny stocks. Many such companies trade on OTC markets, which don't require them to give investors as much information as firms listed on major stock exchanges. Often, such companies are new and lack proven track records.
Low trading volumes may be an indication of a deteriorating company reputation, which will further affect the stock's returns. It may also be an indication of a relatively new company that has yet to prove its worth.
5. Uncertainty About the Larger Picture
What are the real underlying reasons behind the low trading volume of the stock? Why is there no interest or a wider audience for trading this stock?
Other key questions include the following:
- What is a reasonable price for this stock?
- Are prices high because someone bought up many shares recently, or is it the other way around?
- Are prices low because a big investor dumped shares on the market?
- Is the company involved in some irregularities that cause its shares to be too risky for most traders?
6. Susceptibility to Promotion
Company promoters are best informed about the realistic valuations of a stock. Low trading volumes often lead to temporary periods of artificially inflated prices. That allows promoters to offload their large shareholdings to common investors.
Sometimes, this situation can cross the line from perfectly legal self-promotion to illegal pump-and-dump scams.
7. Vulnerability to Marketing Misconduct
Dishonest brokers and salespeople find such low volume stocks an excellent tool to make cold calls with claims of having the insider information on the next so-called tenbagger. Other practices involve issuing fraudulent press releases to lie about prospects for high returns. Many individual investors can fall prey to such practices.
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.