Tuesday, 7 August 2012

Trading in illiquid shares

I have recently found myself investing in smaller capitalisation companies for several reasons
  1. The risky nature of these businesses and the current 'risk off' environment means that many are trading very cheaply and (in my view) a discount to long run valuations
  2. They are not as well covered by institutions and large shareholders so the level of sophistication of the investors and their ability to evaluate news in a timely manner is less than for large capitalisation companies which gives an added advantage
Buying illiquid stocks

I have found that if you can be disciplined with your price and set your buy orders as limit orders then there is no real problem in getting into these stocks.  It may take you longer than you hope or expect but you will get there in the end.  A couple of tips when buying illiquid stocks:
  • Always set your order as a limit order even if it looks like there are enough shares at the price you want to buy them at to justify a market order - these markets are so illiquid that if you set a market order you can end up spending much more than you intended}
  • Other buyers & sellers will often check the depth (see the orders in the market) to gauge whether they should buy a sell.  If the market allows for it I put my limit order in a little below where I actually want to buy it.  As long as you are top of the list you are still first in the queue
Selling illiquid stocks

One of the bigger problems I have found however is selling out of these positions.  This is because once the stock gets to a level where you have an acceptable return then you want to lock in this return.  However while it is possible to be disciplined about buying these stocks, waiting for sellers to come down to your price the converse is quite hard when you are selling.

Where a stock is especially illiquid (i.e. it does not trade for days at a time and only in very small quantities when it does) you sometimes have to wait days at a time and buyers are only buying the stocks in small quantities.  It is at these times that have a very cheap broker is an advantage.  I use Interactive Brokers (which I have posted about before) and it costs me $6 per trade for Australian stocks which is significantly cheaper than the $20 - $30 most Australian brokers charge.  This means that I can afford to sell stocks in $1,000 lots and only sell when there is a bidder willing to pay a high price and not worry too much about the trading costs.

If you can afford to, the best strategy when selling an illiquid stock is the same as when buying one.  Maintain your discipline and only sell when a buyer is willing to meet your price.  I prefer for my asks to only go into the market when I know they will complete so I do not have a standing limit order in the market.  This is because it gives others the opportunity to 'beat' or undercut your asking price.  The downside to this is that you will miss out on buyers that are willing to buy at any price (i.e. submit a market buy order)

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