|
March 5, 2000
Many people new to trading stocks have dreams of buying a small unknown "penny" stock that sells for less than one dollar and watching it double and triple. While this strategy can work, one of the most important issues to research is the average daily trading volume of the stock, also known as the average number of shares traded for the day (aka liquidity).
Before you buy any stock, whether it is a "penny" stock or Microsoft, you should do your due diligence. At the minimum, this should include reviewing the financial statements of the company, the recent price charts, company news, overall market trend, and the average daily number of shares traded (see related article How to Pick A Good Stock - Get an "A" in Research). Pay particular attention to the average daily volume figure. It's our opinion that stocks trading under a daily average of one million shares a day are riskier investments.
When you want to sell your mutual fund shares, the fund must buy back the shares and return your money to you. Therefore the market in mutual funds is liquid. Stocks on the other hand are traded in an open market/barter type environment. The more buyers and sellers there are in a stock the easier it will be to find a buyer when you want to sell. Low volume stocks usually have very wide bid/ask spreads and don't provide the liquidity to exit the stock when the stock may be dropping in price. Unlike a mutual fund, if no one wants to buy your shares of stock when you want to sell them you are stuck with them. This can be financially devastating especially if your stock is falling in price very rapidly.
There are many things that we can not control when trading stocks: such as negative news announcements, poor earnings, analyst downgrades, etc. However, if the stock you purchased has good liquidity, averaging over one million shares traded per day, you can at least have some control over the time when you want to exit your investment. Higher trading volume gives stocks price stability.
While many penny and low priced stocks look like a bargain, they have wide bid/ask spreads and can be very volatile due to the lack of liquidity. Make sure you compare the average daily volumes of the stocks you are considering to buy. In our opinion, you may be able to prevent being burned in a fast moving market if you purchase stocks that trade an average of one million shares per day.
|
