Be Aware of the ‘Spread’ Between a Stock’s Bid and Ask Prices
One of the biggest challenges in investing can come from the smallest of small-cap stocks. Once you find a bargain of a microcap stock, you may find it difficult to buy the number of shares you want. Buck up, friend. The largest fund managers have an even harder time buying huge positions of even the most widely held stocks. Liquidity — how easily you can buy and sell the number of shares you want — can strongly influence portfolio performance, even if you’re just beginning your investing career.
Stocks are sold to the highest bidder and bought from the seller with the lowest price. Since one share of a company is exactly equivalent to another share of the same company, the only quality that differs between those two shares is the price at which each owner is willing to sell. Supply and demand move prices. Think about your local real estate market. If there are few houses for sale and many willing buyers, real estate prices go up. If there are many sellers and fewer buyers, the sellers will keep adjusting their prices down until either they sell or wait for a better price.
Big Spreads Can Be Costly
There are two facets to market liquidity. The easiest to read is the spread between the bid and the ask. The bid price is what you can sell a share for and the ask price is what it will cost to buy a share. For larger stocks, the “spread,” as it’s called, is often only a penny during normal trading hours. But for thinly traded stocks, the spread can be all over the place. Even if it’s a penny, if the stock is offered at 2 cents and someone will buy it for a penny, you’re down by half as soon as your buy is executed. And, yes, I do mean executed in that case.
Although most investors are aware of the impact of commissions and taxes — especially if they had to pay short-term capital gains taxes — liquidity is a hidden cost of frequent trading. That spread cost can pile up for frequent traders and seriously impact the value of your portfolio.
Market Depth
Although fund managers are no fans of paying big spreads, their day-to-day concerns are usually more focused on their ability to seamlessly get in and out of positions without disrupting the market. Bid and ask prices are listed for a limited number of shares. A manager might buy the first thousand shares of a stock for $10, then the next thousand shares available might be for $10.10. That drives the share price up by 1%, which reduces the upside. A friend of mine who runs a $1 billion fund of only
a few stocks once told me that even in the largest, most popularly traded stocks, he could move the price by a couple of percentage points if he sold one of his positions quickly. Fund managers often find it difficult to buy the number of shares they need to impact performance without killing the upside. That’s why larger funds often have so many holdings.
The alternative to holding many different stocks is to slowly accumulate positions when shares are available at the right price, but that carries the risk of missing the investment opportunity. Liquidity also helps explain why a stock’s price can fall dramatically. If many fund managers are selling at the same time and there are few buyers, the
price will have to fall until investors are attracted to taking the other side of a trade.
Depth is the number of shares available for sale or wanted to purchase. It can be difficult to get a precise indication of market depth without expensive data subscriptions, but trading volume and spread provide good indications. If a stock trades 200 shares a year and the bid is half the offer, it’s easy to believe you’ll have a hard time selling the stock when you want at a price close to what you paid. Stocks that are part of major indexes such as the S&P 500 will trade thousands and sometimes millions of shares a day, so our paltry few hundred share orders are unlikely to disrupt the entire market.
Before You Pull the Trigger
Small-cap stocks offer higher potential returns than their large-cap brethren, but the smaller the stock, the more you should consider liquidity before pulling that trigger. Look at price and volume charts to determine whether the potential upside outweighs the liquidity costs and risks. Also be sure to check that bid-ask spread to make sure you aren’t starting off deep in the hole as soon as you buy that stock.
