It’s sort of a joke, but no one’s laughing. The client instructs their advisor: “I want to sell my stock.” The advisor replies, “to whom?” Many investors don’t understand the issues concerning thinly traded stocks.
Many investors might think there’s a giant market out there for any stock you could imagine. If they owned a Honda Civic, they could sell it privately, to a used car dealer, trade it in at a new car dealership or to one of those firms running TV ads saying they buy cars. They don’t understand the vast majority of stock trades take place through market makers.
Here’s another thing they don’t understand. If you researched “public companies headquartered in your area,” you might find “Top 10” lists. If you delved deeper, you might find there are 50! They have ticker symbols. You can get quotes, but the companies might be tiny.
Nine Problems Investors Might Discover
Your client might be excited about a “penny stock” or low priced foreign company. Here are several considerations. These are generalities, but they present issues:
1. Limited number of market makers. Only a very few firms might actively buy and sell the stock. In the bad old days, boiler shop firms would also be selling these shares through their own sales force. This also led to “pump and dump,” running up the price of an unknown stock as the firm’s insiders were unloading their positions purchased earlier at a far lower price. The price to buy and sell is set by this small handful of firms.
2. Spread between bid and offer. Today spreads might be just a few cents. Why? Because the trading volume is so huge! Millions of shares change hands. On a thinly traded stock, the difference between bid and offer, aka “wholesale and retail” can be huge. If you’ve traveled overseas and seen posted exchange rates at a currency exchange shop, you know about wide spreads.
3. 100 shares. OK, you might accept the spread is larger than expected. Generally speaking, the market maker might only be committing to buy or sell 100 shares at that price. If you were to sell 10,000 shares “at the market” you might find the price pulls back sharply, executing your trade in pieces at lower and lower selling prices.
4. Spreads can widen. If there’s little activity, the market maker might widen the spread, since they are incurring a cost (and a risk) holding inventory of the shares on their books.
5. Might not be marginable. If the stock it thinly traded, it might not be eligible for margin and your firm. You would be buying it with 100% cash or borrowing against other securities you own. This would affect short selling too, if the stock couldn’t be borrowed.
6. Does your firm’s research cover it? It’s important to know what you are buying. Does your firm have an industry analyst following the stock? How about independent research? If the major firms don’t cover it, that’s a red flag.
7. Overseas firms. Is this small firm located in another country? Accounting standards are different in some other parts of the world. This is another reason why research coverage, either from the major firm you work with or independent outside research is important. You want a firm with research analysts on the ground in that country. If something goes wrong, local people are the first to know.