Liquidity matters. And it can be an issue in a market like Australia that has more than 1000 smaller stocks that trade only infrequently.
The reason it’s an issue is simple. Trading shares in illiquid stocks can be slow and be associated with major price fluctuations.
Shares are considered liquid if they can be quickly bought or sold without the trade causing significant price movements. For a small retail investor this might be possible with a small cap stock that still has regular trades, while for a large institutional investor with millions of shares in a company they wish to trade, this might require a larger capitalized corporate with a higher market value and bigger daily trading volumes.
There are plenty of ways of finding liquidity data. The Australian Stock Exchange and broking sites such as CommSec display the trading volumes for all ASX listed companies for the past 12 months.
A potential trader can also access the price, volume and total daily trade for the day of their enquiry. These are all keys to understanding how quickly a stock can be bought and sold, and at what price.
And while the likes of famed investor Warren Buffett once told his shareholders that “if you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes,” this isn’t the case for everyone. Some investors don’t want to stick with a stock going through short-term trading problems, or simply want to allocate the funds to another company. It could be that for personal reasons an investor needs access to funds – for example, because they want to buy into the property market – and needs to convert their share portfolio into cash.
There is also a sentiment among many investors that trading in relatively illiquid stocks is higher risk. Being unable to sell shares in a company, or needing to sell them at a significant discount, can be an expensive problem.
At the same time, some traders might take the view that illiquid stocks can be fertile hunting ground. If someone needs to sell out of a stock, triggering a price drop, it can be seen as a buying opportunity.
And for the Buffetts out there who feel confident they’ve found a good thing, smaller capitalized stocks can sometimes turn into the next hot property.
For example, accounting software company Xero had a $NZ55 million market value at its initial public offering in New Zealand back in 2007. The company is now traded on the ASX as well and in the eight years since listing, has grown to a market capitalization of more than $A2 billion.
But even at this scale, the stock price can whip around sometimes. In February this year there was a sudden spike in Xero’s share price on heavier trading volumes. The ASX asked the company why this was happening and Xero responded that it could have been due to positive response from its investor road-show. But in its official response, which you can find on the ASX website, it also noted the typically low trading volumes for Xero shares meant the price could be subject to significant movements, especially when trading activity increased.
From little things, big things (can) grow.
More Invest In Yourself:
- 5 common strategies used by professional traders
- What all traders need to know about market moves
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