Thinly traded shares are those which cannot be easily sold or exchanged for cash without a significant change in price. Thinly traded securities are often exchanged in lower volumes, and have a small number of interested buyers as well as sellers. This can lead such securities to volatile changes in pricing when a transaction occurs. Such securities have often been referred to as illiquid. Thinly traded securities basically trade at a lower volume and exhibit an increase in volatility. Often, thinly-traded companies trade on exchanges that are over-the-counter.
How Do Thinly Traded Shares Work?
Thinly traded securities can be determined by wide bid-ask spreads as well as a low volume. In general, these securities pose a slightly greater risk than liquid investments. As mentioned earlier, thinly traded securities often exist outside the national stock exchanges. This is why the lack of ready sellers and buyers usually leads to larger disparities between the asking price and the bidding price.
Suppose a seller sells at a lower bid price or buyer purchases the security at a high ask price, the securities price itself can experience a significant move. Since the smaller number of participants easily impact the market price, this makes way for a liquidity risk, making thinly traded securities riskier than liquid assets.
Significance of thinly traded shares
In thinly traded shares one sees larger ask/bid shares which generally signifies larger profits for a dealer. One of the key aspects of the bid and asking price is that the sellers receive the bid price while purchases pay the asking price. This subtlety is how traders earn revenue using a bid-ask spread. The trader simply buys stocks at the asking price and sells it at the bidding price. Hence, the size of the spread is directly proportional to the size of the earnings made from it.
A bid/ask spread makes illiquidity easy to measure, but liquidity risk itself is harder to grasp and predict. The chance that the spread will grow to a concerning size always exists. The worst-case scenario is that the thinly traded security will have to be sold off quickly while the investor incurs a loss. There can be more problems that a thinly traded security can compound into. Suppose an investor trading thinly traded shares is not able to liquidate their position, this could keep them from meeting their outstanding debt obligations.
Illiquidity increases the credit risk of an investor. Investors who use a buy-and-hold strategy typically encounter fewer problems when thin trading since they aren’t generally interested in buying and selling securities quickly. This holds true for bond investors who are employing a buy-and-hold tactic, or those investors who are simply awaiting maturity from their bonds without being concerned about interim movements in price.
Advantages of Thinly Traded Stocks
There are some potential advantages of using thinly traded securities to trade. Firstly there is the potential short-term appreciation seen in this thinly traded example. Suppose a thinly traded stock suddenly grabs the attention of investors, even a slight increase in its demand can trigger massive growth in the share price.
For instance, suppose a stock normally trades at 2000 shares a day, and a favorable article comes out about it in a reputable financial journal the following day. Demand could soar upto 10000 shares in a day just from that individual favorable coverage, driving the share price significantly higher in a few days alone. Ultimately, one can see large profits for those who chose to hold onto the thinly traded stocks before they gained popularity.
Secondly, there is the repurchasing of thinly traded stocks at bargain prices during market dips. This thinly traded example showcases how they can be repurchased at a bargain price. Let’s say an investor sells a huge percentage of their shares in a thinly traded stock. Following this, the price is likely to go down since the supply of the shares may likely exceed their demand. Suppose you intend to accumulate extra shares of a thinly traded security, watch for price dips so you snatch up the shares at a bargain price.
Thinly traded securities are a somewhat high-risk lucrative way to trade in low volumes but leverage high volatility. This way one can experience both short term and long term capital appreciation due to the volatile nature of these securities.