Stocks available for investors on the stock market are often characterized as either liquid or illiquid. This article explains what an illiquid stock is, and defines the features of an illiquid stock. We will also understand how investors can identify an illiquid stock
What is an illiquid stock?
An illiquid stock is a stock that cannot easily liquidate due to low volume, lack of trading on the public market, or demand by private investors, and others. Illiquid stocks tend to be high-risk. This is due to the fact that they are investments for which buyers and sellers are not readily available. However there are some stocks that are traded in multiple exchanges and over-the-counter (OTC). OTC stocks can sometimes have a main listing in a foreign stock exchange. However they might be available to US investors through OTC. This means that the stock has most of its trading volume on its main exchange, and the OTC stock might have a low volume.
Penny stocks are also known for being illiquid. Due to the fact that these companies tend to be smaller in size, and have a lower market capitalization – the trading volumes also tend to be lower. The fact that most of these stocks are not so well covered by analysts, and do not capture investors interest, they tend to have low trading volumes, therefore being illiquid.
However, sometimes these stocks can be sold with a significant discount compared to their potential values. Stocks of companies in an early stage are often illiquid stocks because they lack a strong secondary market. The lack of a strong secondary market for illiquid stocks is a result of so many regulatory restrictions on the transfer of the stocks and a lack of track records. So, illiquid stocks have a low trading volume, and sellers cannot easily sell.
Features of illiquid stocks
Low trading volumes
Low trading volume is one of the features of an illiquid stock. On an extremely illiquid stock, that means that there are only a handful of buyers and sellers everyday. For that reason the trading volume tends to be extremely low. The low trading volume can directly influence the volatility, and can indirectly affect the stock price. Therefore, a single large order of the stock from any institutional investor or retail investor can influence the price behavior.
Difficult technical analysis
Technical analysis which is mostly traders often use for their trading does not work the same way as a liquid stock. When we compare with highly liquid stocks, the low volume does not allow the use of technical analysis in the same way. For this reason it becomes difficult to trade illiquid stocks, since a few large orders can quickly change the direction of price. A few orders can push the price in either direction and this renders technical analysis pretty much useless.
Difficult price fills
Price fill simply refers to the price at which buy or sell orders are filled. The price filled with an order differs depending on the volatility of the stock. The price fills for illiquid stocks can be very wide. Therefore, the traders of illiquid stocks can continue to be at a loss. Until the price of the stock moves up or above the price at which it was filled. If you are trading an illiquid stock it becomes difficult to generate a profit in the short-term, since the price at which the order is filled can heavily influence profits.
A spread simply refers to the difference between the bid-ask spread. Most liquid stocks enjoy tighter spreads, due to their high trading volumes. While illiquid stocks usually have wide spreads. This is a reflection of the number of buyers and sellers in the market for a particular stock. With that in mind, the wider the spreads of an illiquid stock, the worse the price fills.
How to identify an illiquid stock?
There are certain signs to consider to determine whether a stock is illiquid or not. These signs include:
- Low volume: If a stock has low trading volume daily, there is a high tendency that it will be illiquid.
- Low values: If a stock is regularly hitting its lowest value, that is a sign of illiquid stock.
- Wide spreads: If a stock has a wide difference between bid price and ask price, it is an indication of illiquid stock.
- Low interest: If a stock has low interest from institutional investors, it is a sign of illiquidity.
Should investors buy or sell illiquid stocks?
Although the liquidity of a particular stock should not be the determining factor for investors to decide whether to invest or not, it should always be considered. Broadly speaking, if you are planning on speculating in the short-term, then you should avoid illiquid stocks, due to the high spreads and low volumes. This can have a particularly negative impact on the returns you expect. On the other hand, if you pretend to hold a stock for a long-term, liquidity should not be your main concern. However it is wise to keep in mind that if you ever sell the stock you might have to do it over several days. This is to avoid moving the market with just a few orders.
Image source: sslinvest