THE CHALLENGES OF THINLY TRADED STOCKS

Introduction

Thinly traded stocks, known for their low liquidity and trading volume, present a unique set of challenges for investors. Understanding these challenges is essential for anyone considering an investment in these types of stocks. This post delves into the main difficulties associated with thinly traded stocks and offers insights into why they might still appeal to novice investors. We’ll also explore strategies for those determined to trade in this risky market segment, including the application of the CAN SLIM strategy and considerations for analyzing chart graphs.

Understanding the Challenges of Thinly Traded Stocks

Low Trading Volume and Its Implications

Thinly traded stocks are characterized by their low trading volumes, which can complicate executing large orders without impacting the stock price significantly.

This is the main reason why thinly traded stocks tend to be too volatile.

Wide Bid-Ask Spreads

Thinly traded stocks are often characterized by wide bid-ask spreads, which increase the cost of trading and make it challenging to secure favorable prices. The primary concern with these spreads is the requirement for the stock to significantly appreciate for the investor to achieve a profit.

At first glance, a difference of a few cents in the bid-ask spread may not seem substantial. However, these small margins can be pivotal, potentially determining whether an investment results in a slight profit or a minor loss. This highlights the crucial role of bid-ask spreads in the overall outcome of stock investments.

Price Volatility

Lack of Information and Transparency

Thinly traded stocks are frequently associated with smaller companies, which often leads to a significant lack of information regarding their financial status and growth potential. This scarcity of data poses a challenge for investors who seek to make informed decisions, as there is limited insight into the company’s operational and financial health.

The limited availability of detailed financial reports, market analysis, and expert opinions on these smaller companies exacerbates the difficulty in assessing their true value and growth prospects. Investors, therefore, face the challenge of making investment decisions with incomplete information, which can increase the risk of such investments.

Market Manipulation Risks

Thinly traded stocks, known for their vulnerability to price manipulation, present heightened risks, particularly for uninformed investors. Large investors and some institutions can exert significant influence on the stock prices of these thinly traded assets.

This susceptibility stems from the ability of such entities to trade in large volumes, overwhelming the typically small market size of thinly traded stocks. Their substantial trades can disproportionately impact the stock prices, leading to potential market manipulation.

Difficulty in Exiting Positions

Selling large quantities of thinly traded stocks can result in notable price declines, potentially trapping investors in unfavorable positions. This phenomenon poses a major disadvantage for institutions, as their substantial holdings mean they often can’t liquidate their positions without influencing the stock’s price.

Even for positions worth only a few hundred thousand dollars, these challenges can emerge with thinly traded stocks. Their limited trading volume means that even relatively small trades can significantly impact the market price, affecting both institutional and individual investors alike.

Limited Analyst Coverage

The lack of professional analysis on thinly traded stocks can obscure their potential risks and advantages.

Regulatory Challenges

Some thinly traded stocks may not meet major stock exchanges’ listing requirements, leading to less regulatory oversight.

Investor Perception

The perceived higher risk of thinly traded stocks can deter investment, further reducing their liquidity.

The Appeal to Novice Investors

Perceived Opportunity for Large Gains

Beginner investors are often tempted by the chance of making big profits from stocks, especially when they hear stories about stocks rapidly increasing in value. But usually, the price of these stocks is reasonable, and the big jump in their value that investors hope for usually doesn’t happen.

Lower Price Per Share

The performance of a stock portfolio is primarily determined by the percentage change in stock prices, not the price per share or the number of shares held. This means that the focus should be on how much the value of the stocks has increased or decreased in percentage terms, rather than on the absolute price per share or the total number of shares owned. For example, a 10% gain on a stock priced at $10 is the same in terms of return as a 10% gain on a stock priced at $100, assuming the same amount of money is invested in each.

Beginners with limited budgets might find low-priced stocks, often from thinly traded companies, appealing because they can buy more shares with their limited funds. However, this can be misleading. Thinly traded stocks, due to lower liquidity, often exhibit higher volatility and may carry higher risks compared to more actively traded stocks. Additionally, the low price of these stocks does not necessarily indicate value or potential for significant returns. It’s important for investors, regardless of budget size, to evaluate stocks based on potential performance and risk factors, rather than being swayed by the low price per share and the ability to own a larger number of shares.

Simplicity of Business Narratives

Smaller companies with straightforward business models can be more appealing to beginners than complex, multinational corporations. Although simplicity could be the key to success, it is not always the case. When you simplify the business model that doesn’t work, simplification might be useless.

Vulnerability to Market Manipulation

Market manipulation represents a significant risk, particularly for novice investors who are just beginning their journey in the investment world. This phenomenon occurs when individuals or entities attempt to artificially influence the stock market for personal gain, often leading to misleading information about the value and performance of certain stocks. Novice investors, with limited experience and understanding of the market dynamics, can be especially vulnerable to such deceptive practices.

Novice investors are often less familiar with the warning signs of market manipulation, such as sudden, unexplained stock price movements, unusual trading volumes, or suspicious news releases. These indicators can be subtle and easily overlooked by those new to investing. Additionally, beginners might not have access to the same level of resources and tools that seasoned investors use to validate information and make informed decisions. As a result, they may unknowingly base their investment decisions on distorted market information, leading to potentially significant financial losses.

New investors must be aware of the risks associated with market manipulation. Gaining knowledge about how the stock market operates, being skeptical of “too good to be true” investment opportunities, and conducting thorough research before making investment decisions are key steps in protecting oneself from falling victim to such schemes. Seeking advice from financial professionals and utilizing reputable sources for investment information can also be beneficial in navigating the complex world of stock market investing. Remember, an informed investor is a safer investor, especially in the intricate and often unpredictable financial markets.

Overconfidence in Stock Picking

For beginners in the stock market, it’s easy to fall into the trap of overestimating one’s ability to spot undervalued stocks. This overconfidence can lead to risky investments in thinly traded stocks, which I have personally experienced several times. When we, as novice investors, start delving into investment literature like Benjamin Graham’s ‘The Intelligent Investor’, there’s a tendency to feel empowered, almost like mini Warren Buffetts, ready to scour the market for hidden gems.

However, this approach doesn’t always pan out, as I’ve learned through my own experiences. The stock market is incredibly dynamic, and all investors have access to the same information. Often, if a stock is priced low, there is a valid reason behind it. New investors need to understand that while education and research are crucial, they don’t instantly equip one with the expertise to consistently identify undervalued stocks. Caution and a realistic assessment of one’s skill level are key when venturing into the world of stock market investing. Remember, learning to invest wisely takes time, and it’s okay to start small and grow your skills gradually.

Misunderstanding of Liquidity

Liquidity in the stock market is a concept that often goes misunderstood, especially among novice investors. While individual trades may seem unaffected, the overall liquidity of the market plays a crucial role in the stability and efficiency of stock prices. Liquidity refers to how quickly and easily a stock can be bought or sold in the market without affecting its price. High liquidity means there are enough buyers and sellers at any given time to execute trades promptly, which leads to more stable prices.

Beginner investors might not immediately see the impact of liquidity on their personal trades, especially if they are dealing with small amounts. However, it’s the market’s overall liquidity that ensures smoother transactions and more accurate pricing for everyone. In markets with low liquidity, even small trades can significantly impact stock prices, leading to higher volatility and increased risks. This can make it challenging for investors to exit positions at desired prices and can result in unexpected losses.

Understanding the broader implications of market liquidity is essential for new investors. It’s not just about the ease of trading individual stocks, but also about the health and predictability of the market as a whole. Novice investors should be aware of the liquidity levels of the stocks they are interested in and consider how these levels might affect their investment strategies. Recognizing the importance of liquidity can help in making more informed and strategic investment decisions, ultimately leading to a better investing experience.

Trend Chasing

Limited Research

I’d like to clarify that I’m not a proponent of conducting extensive research on every company before making an investment. I also don’t classify myself as a traditional investor. Additionally, it’s important to note that this website is not primarily focused on investing.

Typically, my investment decisions are made rather swiftly, often within less than 5 minutes. However, these quick decisions are guided by a specific set of procedures that encompass both fundamental and technical analysis. What exactly are these procedures? Well, they revolve around a strategy known as CAN SLIM, and that’s precisely what this website is all about.

Now, do all the stocks I choose adhere strictly to the CAN SLIM criteria? No, they do not. But when I do decide to invest in a stock that doesn’t align perfectly with CAN SLIM principles, I’m fully aware of this fact. Consequently, I’ll usually opt for a smaller position in such stocks, as compared to those that meet the CAN SLIM criteria.

Strategies for Trading Thinly Traded Stocks

Assessing Risk Tolerance

It’s crucial to understand and accept the high risk involved in trading thinly traded stocks. The main thing to point out is that since these stocks are volatile, you need to be more careful which means that you should place very small bets and hold tight (3 to 5 percent) stop-losses. Also, it is important to time the buying decision.

Conducting Thorough Research

It’s important to delve into the company’s financial stability, its business model, and the overall condition of the industry it operates in. As mentioned earlier, research is indeed crucial, but it’s typically effective when it’s concise and focused.

I would liken stock investing to more of a wager on a horse race rather than an investment in real estate properties. Just like even the swiftest and most robust horse can encounter injuries or off days that impact its performance, stocks can also be influenced by unforeseeable events. The timing of their recovery remains uncertain, much like the unpredictability of horse races.

Understanding Liquidity and Bid-Ask Spread

Check the stock’s liquidity and be mindful of the wider bid-ask spread, which can affect trading costs. The bid-ask spread is the additional cost with for stock investing and trading next to the transaction costs.

You can’t get rid of it but it is crucial to pay attention to it. When you buy a stock and want to sell it immediately and you are forced to sell it 10% lower for example, that is not good.

Strategic Position Sizing

Invest only a small portion of your portfolio in thinly traded stocks to manage risk. Your position size should be small, up to 5% of the portfolio’s worth per one stock for example. It should be so small that you can sleep at night.

Developing Entry and Exit Strategies

Have a clear plan for when and under what conditions you will enter and exit your positions. As told earlier, stop-losses need to be tight. Also, profit target should be at least twice as far as the stop-loss.

Choosing Order Types Wisely

Prefer limit orders to control your buy or sell price in a market with low liquidity. If the stock is thinly traded, it is very important to use limit orders. When trading the stocks that have a bigger volume (more than 400,000 shares per day for example) you could use market orders as well.

Staying Informed and Avoiding Emotional Trading

What about reading or listening to the news? The best traders in the world from history and also today, rarely follow the news. The news tends to distract us. The news is already old. In my opinion, The only news we need to follow are the stock charts. These are the most up-to-date news that matters.

Diversification

In the context of stock trading, the advice to “Spread your investments across different assets to mitigate risk” emphasizes the importance of diversification. Diversification is a key strategy in stock trading and involves allocating investments across various financial instruments, industries, and other categories to reduce exposure to any single asset or risk. The idea is that by spreading your investments, you’re less likely to suffer significant losses if one of your stocks performs poorly since other investments might offset the loss.

However, the phrase also cautions against buying stocks solely for diversification. In stock trading, it’s crucial to make informed decisions. This means not just buying a stock because it adds diversity to your portfolio, but also considering the stock’s potential based on thorough research and analysis. Since stock prices and company performance are subject to many unpredictable factors, like market fluctuations and management decisions, the advice suggests that it’s risky to place too much emphasis on any single stock. Instead, a balanced approach that combines diversification with careful stock selection based on solid research is recommended for stock traders.

Effective stock trading is about striking the right balance between spreading risk and making informed investment choices.

Applying CAN SLIM in Thinly Traded Stocks

The nuances of applying the CAN SLIM strategy to thinly traded stocks. The CAN SLIM method, a renowned investment strategy, focuses on a mix of fundamental and technical analysis to pick high-potential stocks. However, when it comes to thinly traded stocks, this approach requires some specific considerations.

C – Current Quarterly Earnings

The heart of the CAN SLIM strategy begins with focusing on stocks that have significant increases in earnings per share (EPS) in the most recent quarter. It’s crucial to ensure the sustainability of these earnings, which is a strong indicator of a company’s health and potential for growth. Learn more about EPS.

A – Annual Earnings Growth

Annual earnings growth is another cornerstone. Look for companies with a consistent and strong record of year-over-year earnings growth. This growth should be rooted in solid business fundamentals. Read more on annual earnings growth.

N – New Product, Service, or Management

In thinly traded stocks, identifying companies that are introducing new products, services, or undergoing a management overhaul can be a key growth catalyst. Such changes often bring fresh momentum and interest in the stock. Understand the impact of new offerings.

S – Supply and Demand

The balance between supply and demand in thinly traded stocks is delicate. Limited supply coupled with low liquidity can present unique challenges and opportunities. Explore supply and demand dynamics.

L – Leader or Laggard

Favor stocks that are leaders in their industry. However, be mindful of artificial price inflation, which can be a risk with thinly traded stocks. Know the difference between leaders and laggards.

I – Institutional Sponsorship

Look for thinly traded stocks with some degree of institutional ownership, ensuring that these institutions are reputable. This sponsorship can lend credibility and stability to the stock. Read about institutional sponsorship.

M – Market Direction

Always align your trades with the overall trend of the market. However, in thinly traded stocks, be prepared for more unpredictable reactions to market trends. Learn about market trends.

Each of these components plays a crucial role in applying the CAN SLIM strategy effectively, especially in the context of thinly traded stocks. This chapter will guide you through these elements, offering insights into how to tailor the CAN SLIM strategy for these unique investment opportunities.

Analyzing Chart Graphs

Identifying Trends

Determine the stock’s general trend direction, observing patterns like higher highs or lower lows. It is also useful to determine support and resistance levels and lines.

Usually, a good support line is a key moving average (eg EMA 21, SMA 50 or SMA 200).

Volume Analysis for thinly traded stocks

Use trading volume to confirm trends, but be cautious with thinly traded stocks. When a stock has a strong price action in one direction that is supported by bigger than average volume, that is a strong sign.

Recognizing Chart Patterns

In the realm of CAN SLIM trading, a key strategy involves analyzing chart patterns to predict potential future movements of stock prices. These patterns, like the ‘cup with handle’, ‘double bottoms’, and others, are visual indicators that traders scrutinize to gauge the market’s sentiment and to forecast the direction in which a stock might move. Recognizing these patterns can provide a strategic advantage in making informed trading decisions.

Another crucial aspect to consider in chart pattern analysis is the identification of tight areas. These are sections within the chart patterns where the price movements are constrained within a narrow range. The presence of tight areas often signals a continuation of the current trend. Paying attention to these areas can offer insights into whether a stock is likely to maintain its current trajectory, which is an essential factor in making successful trading choices in the CAN SLIM method.

Contextualizing Market Performance

Place the stock’s movement within the broader market context. This is the ‘M’ part of the CAN SLIM formula.

Overall market direction plays an important role in stock investing and trading. The reason is that 75% of the stocks tend to move the same way that the market does.

Historical Performance Analysis

Review the stock’s past performance in similar market conditions.

Noticing Gaps

When you trade stocks, actively consider round numbers and historically significant levels as potential psychological barriers or targets. These levels often indicate key support or resistance points in the market. However, when setting stop orders, it’s better to avoid these exact round figures.

For instance, if you buy a stock at $106, don’t set your stop-loss at the $100 level. This round figure might act as a psychological support level, where the stock briefly dips and then rebounds. By setting a stop-loss at $100, you risk an unnecessary exit from your trade. Instead, set your stop-loss at a more unique figure, like $99.78. This approach can help you evade the pitfalls of round number levels and protect your investment from short-term market movements.

Conclusion

While thinly traded stocks offer the potential for high returns, they come with significant risks. Investors should approach these stocks with caution, thorough research, and a well-thought-out strategy. Balancing the lure of potential gains with an understanding of the inherent risks and complexities is key to navigating the world of thinly traded stocks successfully.

Additionally, analyzing the ‘CAN SLIM’ strategy on a word-by-word basis reveals that thinly traded stocks typically don’t meet its criteria. Specifically, the strategy recommends that a stock candidate should have a minimum average daily volume of 400,000 shares, a threshold that thinly traded stocks, characterized by their low volume, usually don’t reach.