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Beginners Guide on Illiquid Stocks

11 Oct 2023

What are Illiquid Stocks?

Illiquid stocks refer to securities that are not easily tradable in the market due to their low trading volume and infrequent trading activity. These stocks often pose unique challenges for investors, but they also present opportunities for those who understand how to navigate them effectively.

Features of Illiquid Stocks

Illiquid stocks exhibit several distinctive characteristics that set them apart from their liquid counterparts. These characteristics include:

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  1. Low Trading Volume: Illiquid stocks typically have a limited number of shares traded daily. This low trading volume can result in challenges when attempting to buy or sell these stocks. Stocks with consistently low trading volumes are more likely to be illiquid.
  2. Wide Bid-Ask Spreads: The bid-ask spread, which represents the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask), tends to be wider for illiquid stocks. This can lead to price discrepancies and increased transaction costs. A substantial difference between the bid and ask prices can make it challenging to execute trades.
  3. Infrequent Trading Activity: Illiquid stocks often experience long periods without any trading activity. Investors may find it difficult to execute trades promptly.

Factors that contribute to the existence of Illiquid Stocks

There are several distinctive factors that set illiquid stocks apart from their liquid counterparts. These factors include:

  1. Limited Public Interest: Some stocks are not widely followed by investors and analysts, leading to limited interest and trading. A potential reason for this could be that companies in niche industries or with unconventional business models may have limited appeal to mainstream investors.
  2. Small Market Capitalization: Companies with a small market capitalization may have fewer outstanding shares available for trading to retail investors, thus reducing overall trading activity.

​Impact on Investors

Illiquid stocks can significantly impact investors in various ways. Investors may struggle to buy or sell illiquid stocks at desired prices, which can lead to frustration and missed opportunities. Illiquid stocks can be more susceptible to price manipulation and extreme price volatility due to their low trading volumes.

Strategies for Handling Illiquid Stocks

Investors can employ several strategies to manage illiquid stocks effectively: Holding illiquid stocks with a long-term perspective allows investors to weather short-term price fluctuations and benefit from potential future gains. Using limit orders can help investors specify the price at which they are willing to buy or sell illiquid stocks, providing more control over execution.

​Final Thoughts

While illiquid stocks pose challenges, they can also play a valuable role in a diversified investment portfolio. Including illiquid stocks can enhance portfolio diversification, potentially reducing overall risk. Investors must weigh the risks and rewards associated with illiquid stocks to determine their suitability in a portfolio.

 

Related Articles:  Can the Schaff Trend Cycle Help Identify Trend Reversals in Trading | A Complete Guide on Forfeited Share | Hockey Chart Patterns: What it is and How to Use it

 

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