Illiquid Stocks cannot easily be sold on the Exchange. Market Cap is an indication. Nanocap or Microcap Stocks, Volume, Free Float and Price Spread are also factors. Limited investor interest could be an issue.
A stock’s level of liquidity is one factor often overlooked by Stock Investors. at the point of investing, in monitoring a Stock holding often only discovered at the point of attempting to sell the Stock. The potential for a Stock to become illiquid is a major risk to the Share Price and is exacerbated as the Share Price falls. Illiquid Stocks are generally thought of or classified in terms of the size of their Market Cap, so Nanocap, Penny and Microcap stocks, and this is certainly a good place to start. When Stocks become Illiquid Stocks, they cannot easily be traded in the Stock Market, and thus carry greater risk in their Stock Price. Why or how Stocks become illiquid is more nuanced than simply looking at Market Cap.
Any Stock, independent of Market Cap can become illiquid. The reality is that, in the worst-case scenario a stock can become illiquid due to limited interest by other investors. Apart from limited investor interest, the level of volume traded is key to identifying illiquid stocks. Therefore, as part of the analysis, a clear understanding of the following three points is critical. First, the level of volume traded as a percentage of Market Cap, which can be assessed by analysing the very recent volume compared to Average Daily Volume traded, calculated over the past 3 months. Understand the percentage volume traded compared to other Stocks with a similar Market Cap and the recent trend, if decreasing in Volume, this is a concern.
Second, the percentage Free Float, which is simply the amount in percent of the Stock’s Market Cap, which is freely floated on the Stock Market. The Free Float is the Shares not held by Management or “Insiders”. For example, in the January 2021 trading of GameStop, the short position was 130% of Market Cap. I believe around 14% of GameStop shares were held by the new management. Thus, the short position of the actual Free Float was 50% above, further impairing the Hedge Funds ability to cover their short position. Somewhat subjective, but be aware if the free float is lower than 50%, this is a concern.
Third, the Bid-Ask spread must be taken into consideration. For Stocks with a high volume, the Bid-Ask spread should or will be narrow. Then, if the spread between the Bid-Ask Prices is wide or starting to widen and the Price Volatility is increasing, this is also a concern. A quick way to assess if the Bid-Ask Spread, is wide is to look at the range of the daily Price movements from high to low and if the Bid offered keeps dropping. Avoid illiquid stocks and monitor the liquidity trends of Stock positions currently held, in particular, for Stocks classified as Nanocap, Penny or Microcap Stocks.
Meet the author behind Smartest-Data. Warren William has a career in Finance and Investments extending over 35 years, both on the Buy Side and Sell Side. His most recent roles include, developing Institutional Risk Management Programs for managing Equity and Fixed Income Risk. Prior to this Warren William work in Alternative Investments, in Investment Management and as a Buy Side Equity Analyst. Warren William brings a wealth of knowledge and expertise to the table, providing in-depth analysis and commentary on the latest trends in the Stock Markets. Contact information: wwBLOG@smartest-data.blog or Telegram +393339034488
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