A large part of the stocks are very sparsely traded stocks. These stocks trade irregularly or have low trading volumes. Investors should be aware of the huge risks of trading these low-volume stocks. Next, we will deal with seven major dangers.
There is no need to invest in small batches of stocks. Most investors prefer ETFs, mutual funds and large listed companies.
1. Low liquidity makes trading difficult
One risk of low-volume stocks is their lack of liquidity, which is an important consideration for stock traders. Liquidity is the ability to quickly buy and sell securities in the market without changing prices. This means that traders should be able to buy and sell large amounts of stocks traded at $25 per share, such as 100,000 shares, while still maintaining a price of $25 per share.
Low liquidity can also cause problems for smaller investors because it leads to high bid-ask spreads. Average daily trading volume is a good indicator of liquidity. As a general rule, frequent traders often lose money when liquidity is low.
2. The challenge of profit-taking
Insufficient trading volume indicates that only a few market participants are interested, and they can then earn a premium for trading such stocks. Even if people sit on the unrealized gains of these stocks, they may not be able to make a profit.
Suppose you bought 10,000 shares of a company at a price of $10 per share a year ago, and the price rose to $13. Therefore, you are sitting on 30% of unrealized profits. You want to sell your 10,000 shares and pocket the proceeds. If the average daily trading volume of this stock is only 100 shares, it will take time to sell 10,000 shares at the market price.
The act of selling stocks may also affect the price of small batches of stocks. If demand remains low, flooding the market with a large amount of inventory may cause prices to fall sharply.
3. Manipulative market makers
Market makers active in low-volume stocks can profit from low liquidity. They realize that the low liquidity of stocks means they can take advantage of buyers who are eager to enter and exit the market.
For example, a market maker might bid 100 shares close to the last sale price and bid 1,000 shares 10% below that price. If someone naively tries to sell 1,000 shares at the market price, they may only get their expectations for the first 100 shares and 10% less for the rest. If you want to avoid these losses, you must use limit orders for small batches of stocks.
4. Deterioration of the company’s reputation
Although low trading volumes are observed in stocks in all price segments, it is especially common for microcap companies and penny stocks. Many of these companies trade on the over-the-counter market and do not require them to provide investors with as much information as companies listed on major stock exchanges. Usually, these companies are new companies and lack a reliable track record.
Low trading volume may indicate that the company’s reputation has deteriorated, which will further affect stock returns. This may also indicate that this is a relatively new company that has not proven its worth.
5. Uncertainty of the overall situation
What is the real deep-seated reason for the low stock trading volume? Why is there no interest or wider audience to trade this stock?
Other key issues include:
- What is the reasonable price of this stock?
- Is the price high because someone has bought a lot of stocks recently, or vice versa?
- Is the price low because big investors dumped stocks in the market?
- Is the company involved in any irregularities that make its stock too risky for most traders?
The lack of transparency and the difficulty of price discovery make it difficult for us to see the overall picture of small-volume stocks.
6. Sensitivity to promotion
The promoters of the company know the actual valuation of the stock best. Low trading volume usually results in artificially increasing prices temporarily. This allows the promoter to sell a large amount of its equity to ordinary investors.
Sometimes, this situation may span from completely legal self-promotion to illegal pumping and dumping scams.
7. Vulnerability of marketing misconduct
Dishonest brokers and salespeople find that such a low amount of stock is a great tool to make calls by claiming to have inside information about the next so-called “tenbagger.” Other practices include issuing fraudulent press releases to misrepresent the prospect of high returns. Many individual investors may fall victim to this approach.
The reality is that there is usually no good reason for trading in low-volume stocks-few people want them. Their lack of liquidity makes it difficult to sell even if the stock appreciates. They are also susceptible to price manipulation and are attractive to scammers.
Traders and investors should exercise caution and conduct due diligence before buying small batches of stocks.