Buying a stock with a low share volume – also called a thinly traded stock – can be lucrative but can also subject you to a higher level of risk compared with larger actively traded stocks. Thinly traded stocks can have wider price swings and are susceptible to sudden declines that can limit your profit or quickly turn it into a loss.
What Volume Indicates
Volume is the number of shares traded on a particular day. Multiplied by the stock price, it indicates the dollar amount of transactions. Volume is important because it shows how much investor interest there is in a stock and how much money investors are willing to commit to it. For example, if a $50 stock trades 1 million shares, the daily dollar commitment is $50 million. If a $5 stock trades 50,000 shares a day, the commitment is only $250,000.
Lack of Institutional Support
Lack of institutional interest – or commitment – makes a stock vulnerable to sudden price drops. Institutional investors only buy stocks they can get in sufficient quantity and shun thinly traded issues. When an actively traded stock declines in price, institutions often support it by buying more "on dips," providing a floor under the stock price. Thinly traded stocks lack such support. If a large number of shares in a thinly traded stock is offered for sale, the market may not be able to absorb the supply and the stock price will drop, creating a loss for your position.
A spread is the difference between the bid and ask prices – the highest price at which you can sell and the lowest price at which you can buy. For example: If XYZ is quoted at $3.25 bid, $3.45 ask, you can sell at $3.25 a share and buy at $3.45 – so the spread is 20 cents per share. If you buy 1,000 shares of XYZ but change your mind and sell them immediately, you would suffer a $200 loss, not counting the commissions. By contrast, the spread in larger actively traded stocks may be as little as one cent per share so you can buy and sell them easily throughout the day.
Sharp Price Swings
You may overpay for the shares you buy or get less than they are worth when you sell. Current stock quotes are good for 100 shares. If you were to place an order to buy 1,000 shares of XYZ quoted at $3.45, only the first 100 shares might be sold to you at that price; the rest might be sold at progressively higher prices. After your order is executed, the price may drop back to the $3.45 level. If your average cost was higher, let’s say $3.89, your position will show an immediate loss. A sell order can move the price in the opposite direction – that is, you are likely to get less for your shares than what the current quote would indicate.
Sharp price swings may put psychological pressure on you, causing you to make mistakes. A jump in price will tempt you to "chase" the stock – buy more at higher prices – for fear of missing out on a profit opportunity. A sharp drop in price may cause you to sell for fear of a bigger decline.
- Technical Analysis of Stock Trends; Robert D. Edwards, et al.
Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.