The Top 7 Risks of Trading Low-Volume Stocks

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The Top 7 Risks of Trading Low-Volume Stocks

A considerable portion of the shares are very sparsely traded equities. These stocks trade infrequently or in small quantities. Investors should be aware of the significant dangers associated with dealing in these low-volume companies. Seven of the most serious threats are discussed here.

There is no need to invest in equities with little volume. Most investors are better off investing in ETFs, mutual funds, and major publicly traded corporations.

1. Low Liquidity Makes Trading Difficult

One danger associated with low-volume equities is a lack of liquidity, which is an important issue for stock traders. The capacity to immediately acquire or sell a securities in the market without a price change is referred to as liquidity. That implies traders should be able to purchase and sell a stock selling at $25 per share in big quantities, such as 100,000 shares, while preserving the $25 per share price.

Low liquidity may also pose issues for smaller investors by resulting in a wide bid-ask spread. The average daily trade volume is an accurate indicator of liquidity. When liquidity is scarce, frequent traders often lose money.

2. Challenges in Profit Taking

A lack of trading volume suggests that just a few market players are interested, which allows them to charge a premium for trading such equities. Even if one has unrealized gains on some equities, it may be impossible to extract profits.

Assume you bought 10,000 shares of a corporation for $10 per share a year ago, and the price has now risen to $13. As a result, you have a 30% unrealized profit. You want to sell your 10,000 shares and pocket the profits. If the typical daily trading volume of this stock is merely 100 shares, selling 10,000 at the market price will take some time.

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The act of selling your shares may also have an impact on the price of a low-volume stock. If demand is continuously low, flooding the market with a big quantity of goods might cause prices to decrease significantly.

3. Manipulative Market Makers

Market makers that trade low-volume equities might benefit from limited liquidity. They understand that the stock’s limited liquidity allows them to take advantage of purchasers who are eager to enter and exit the market.

A market maker may, for example, post a bid for 100 shares around the previous selling price and a bid for 1,000 shares 10% below that price. If someone sells 1,000 shares at the market price, they may only receive what they anticipated for the first 100 and 10% less for the remainder. If you wish to prevent these losses, you must utilize limit orders on low-volume equities.

4. Deteriorating Company Reputation

Although low trading volumes are found across all price sectors, they are more typical for microcap and penny stocks. Many of these businesses trade on OTC markets, which do not compel them to provide as much information to investors as corporations registered on major stock exchanges. Such businesses are often new and have little track record.

Low trading volumes may indicate a worsening corporate reputation, which will have an impact on the stock’s returns. It might also be an indicator of a young firm that has yet to show its value.

5. Uncertainty About the Larger Picture

What are the true underlying causes of the stock’s low trading volume? Why is there no interest in trading this stock or a larger audience?

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Other key questions include the following:

  • What is a fair price for this stock?
  • Are prices high because someone just purchased a large number of shares, or is it the other way around?
  • Is it because a large investor dumped shares on the market because prices are low?
  • Is the corporation engaged in any anomalies that make its shares unsuitable for most traders?

The lack of transparency, along with the difficulties of price discovery, makes it difficult to understand the big picture for low-volume companies.

6. Susceptibility to Promotion

Company promoters are the most knowledgeable about stock values. Low trading volumes can result in artificially inflated pricing. This enables promoters to sell their big shareholdings to ordinary investors.

This circumstance may sometimes cross the line from totally lawful self-promotion to criminal pump-and-dump schemes.

7. Vulnerability to Marketing Misconduct

Dishonest brokers and salesmen use such low volume stocks to conduct cold calls claiming to have insider knowledge about the next so-called tenbagger. Other methods include releasing false news releases to mislead investors about the chances for huge profits. Individual investors are vulnerable to such schemes.

The Bottom Line

In truth, low-volume equities are frequently not traded for a good reason: relatively few people desire them. Even if the stock appreciates, their lack of liquidity makes it difficult to sell. They are also vulnerable to price manipulation and appealing to con artists.

Before acquiring low-volume equities, traders and investors should take prudence and do due research.

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