Don’t Ignore This Risk When Trading

For most individual investors, a stock’s liquidity is often taken for granted because you are usually buying and selling in small quantities compared to a typical stock’s daily trading volume. A drop in the ocean, so to speak.

When there’s a lot of trading activity in a stock, you are pretty much going to be able to make your trade whenever you wish. The bid-ask spread is usually negligible so if you just want to do the trade immediately, it’s fine to enter a market order. You will likely get an execution price close to the price of the last completed trade.

The exception is if you want to trade certain obscure stocks, such as micro-cap or little-known foreign stocks traded on the over-the-counter market. In some cases, there may be only a few hundred shares—or even fewer—exchanging hands on a given day. Some may even have literally zero trading volume on some days. The bid-ask spread is usually far larger than for widely-traded stocks. In such scenarios, you need to make sure to use a limit order (instead of a market order) to make sure you only buy/sell at the price you want to.

Why would you want to buy an obscure stock?

Early Mover Advantage

Well, the idea is to be an early investor. A stock is obscure because not many people know or care about it—yet. But if you are right and the company becomes more successful and better well known, more investors will flock to the stock, driving up its price. As an early investor in a stock before it takes off, you are going to achieve a big percentage return on your investment. Think about the investors who bought Amazon (NSDQ: AMZN) in its early days.

However, just because such stocks could have very high potential upside doesn’t mean you should have your portfolio full of them. Such stocks are risky and many of them—perhaps even most of them—probably won’t pan out. It makes more sense to have most of the portfolio invested in a core group of high-quality large-cap stocks and leave a small portion to invest in more speculative, high-risk/high-reward stocks.

When you invest in obscure stocks, the risk is not only that your bullish expectations don’t work out and the stock falls. Because such a stock is thinly traded, exiting your position at a fair price could be a big problem, especially if other shareholders are also rushing to sell. There won’t be enough buyers, and the traders willing to buy will bid low to take advantage of the situation. You may have to take a big haircut in order to sell.

Thus, a stock’s liquidity is an important factor to consider.

Option Liquidity

For stock options, it’s even more important.

Option trading has become more and more popular. In 2020, Goldman Sachs (NYSE: GS) reported that for the first time ever, option trading volume had surpassed stock trading volume.

However, since each stock can have dozens of different options to trade (different strike prices and expiration dates), for each option contract, the trading volume will be much less than that of the underlying stock.

Thus, if you buy or sell an option in a stock that isn’t a widely traded stock, then it will be even harder to exit the option position (if you need to) at a reasonable price. In general, the more liquid a stock is, the more liquid that stock’s options are. And the closer the strike price of the option is to the market price of the stock, the more liquid the option tends to be.

The next time you trade options, besides picking a strike price and expiration date, don’t forget to check the daily trading volume.

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