What are illiquid stocks?

Quite simply, illiquidity is the opposite of liquidity. In the context of a business, illiquidity refers to a company or an organization that does not have the necessary cash flows to fulfill its debt payments. This does not entail that the company has no assets. Capital assets, such as real estate, and plants and machinery, often have high value but are not easy to sell when there is a requirement of cash, otherwise called – liquidity.

The sale of illiquid assets is never a company’s core business. They typically include any property under the ownership of the company, other than the products produced for sale. In case of a rainy day, a company may need to liquidate such assets to avoid bankruptcy or any other form of financial distress. If done expediently, the company can dispose of assets at prices far below the fair market price, sometimes known as a fire sale or a distress sale.

Below, we take a look at the meaning of illiquid stocks.

Illiquid Stocks

Illiquid stocks are high-risk stocks that cannot be easily and readily sold or exchanged for cash without a substantial loss in value, even using a stock trading app. They are difficult to sell as a result of the cost, lack of ready buyers, low trading activity, and other such factors.

Nonetheless, illiquid assets hold value and, in many cases, very high cost. Finding interested buyers is challenging for investors because of the relatively limited trading volume of illiquid stocks. The lack of ready buyers impacts the extent of discrepancies between the asking price – set by the seller, and the bid price – submitted by the buyer. This difference leads to much larger bid-ask spreads than would be found in an orderly market with daily trading activity. The lack of depth of the market (DOM), or ready buyers, may cause the holders of illiquid assets to experience losses, especially when the investor is looking to sell quickly. Usually, these include small stocks that cannot be realized quickly.

Examples:

Some examples of illiquid assets include houses and other real estate, cars, collectibles, private company interests, and some forms of debt instruments. Additionally, certain antiques and art pieces are also considered illiquid assets.

Over-the-counter (OTC) traded stocks are often less liquid than those listed on a sturdy exchange. Although these assets may have a value attached to them, the marketplace in which they are traded often has fewer buyers when compared to those interested in buying relatively more liquid assets.

On the flip side, most listed securities traded in major exchanges such as – stocks, ETFs, mutual funds, bonds, and listed commodities, are very liquid in nomenclature and can be sold almost immediately during regular market hours, at fair market prices.

Precious metals like gold and silver, are fairly liquid. Trade executed after normal business hours may also result in illiquidity. This is the case since many market participants (or potential buyers) are not active during those times.

Depending on several external market influences, the liquidity of an asset may change over time.

How do identify illiquid stocks?

Below are some telltale signs of certain stocks being illiquid. Make sure to analyze the market thoroughly while keeping these pointers in mind.

• Institutional investors showing little to no interest in stock – this is a sign of low performance in terms of return
• The stock does not have enough trading volume daily
• The stock is hitting lower values on a regular basis
• There is a grave difference between the bid price and the asking price

Illiquid stocks have negligible trading volumes and cannot be sold immediately or easily. These assets give a higher yield but at the same time, are harder to sell as compared to liquid assets. Even if a quick sale is made, it may involve a substantial loss in value.

How do I buy illiquid stocks?

We have mentioned below some tips on how one can buy illiquid stock.

• Always buy stocks using the limit order With a limit order, you are essentially telling your broker to buy or sell the share at a certain maximum or minimum price that you determine. This means the order will only be executed if the price is the same or better than the limit you have set
• Don’t use All or None If you are trying to buy 1,000 shares, the chance that you will get all 1,000 shares in one order is significantly low. Build your position in blocks if you have to.
• Try to keep commissions below 1% of your order
• Don’t bid up stocks. Set it and leave that be.
• Stock is always liquid enough for small investors

Final word

Illiquid stock cannot be sold easily because of limited trading. These stocks pose higher risks to investors since it is difficult to find buyers for them as compared to frequently traded shares. While trading, make prudent decisions that are aligned with your financial objectives.