Learn what changes when trading a thinly traded stock compared to a high volume stock. This will help you decide whether you should trade them or not. A thinly traded stock is one which doesn’t do very much volume on a daily basis and typically has a large bid/ask spread.
In the Stock Market Swing Trading Video Course, I mention that we are typically going to be swing trading stocks that do more than 500,000 shares in average volume per day. Trading stocks with lower volume is at the discretion of the trader. There is nothing wrong with trading stocks that do less volume, but thinly stocks require a bit of extra knowledge.
For many traders, thinly traded stocks are the reality of their everyday life. Outside of the US, many global stock markets have a handful of stocks that do lots of volume and a whole bunch that do very little volume.
I’m in Canada, and while I trade US stocks, I also trade Canadian stocks. The Candian market is much smaller, which means that sometimes a good setup will occur in a stock that only trades 20,000 shares per day. There is nothing wrong with that…but in this article, I will discuss what you need to be aware of when trading lower volume stocks.
Things to Know When Trading Thin Stocks
First, you still need everything to line up according to your strategy. Nothing changes in that regard.
Second, the bid/ask spread is typically going to be much larger. If the stock only does 20,000 or 50,000 shares, it may have a $0.20 spread or more if it’s a $50 stock. It may have a $0.05 spread if its a $2 stock. $0.05 on a $2 stock is a lot. That is equivalent to 2.5%! Therefore, use limit orders, not market orders. You have to wait for the price you want. Alternatively, in a thinly traded stock, if you see a setup you like you can take shares when you see them. For example, assume there is a consolidation between $87 and$ 90 and you want to buy the breakout above $90. The stock is approaching $90 again. Watch the level II to see where shares are above $90. If there are very few, you may have to buy them at $90 if those are the only shares you can see. The downside is the breakout may not happen, and the price keeps ranging. The danger in not taking the shares when they are there is that if the stock does break through $90 (often you can cause this yourself if your order is bigger than the shares available for sale at $90) the stock will likely move very quickly higher without you.
Third, you need to give the trades a bit more leeway, which means reducing your position size accordingly. When the spread is large, that means the price can easily move a significant amount with just a few levels getting taken out. Since I usually take trades after a consolidation breakout, my stop loss is usually just below the consolidation low (if going low). On a heavy volume stock, my stop loss may be only $0.05 or $0.10 below the consolidation low. On a thinly traded stock, I will typically put my stop loss about 3x the spread below the consolidation low. For example, if the spread is $0.20, my stop loss is going to go about $0.60 below the consolidation low. This is not a fixed rule, each thinly traded stock is a bit different, but I do tend to give them a bit more room. Since the stop loss moves further away from the entry point, the position size drops accordingly.
Forth, partial fills are common. If a stock only does 50,000 shares on average and you want 10,000, it may take a while to get all those shares you want. The order may need to be split up, taking a few shares each time when you can get them. Or it may take multiple days for your order to fill if you just leave it sitting there. I prefer to watch the Level II, and when a bunch of shares pop up, I send my order to take them, assuming it is a good entry point price. With low volume stocks you need to be patient, but then pounce when the shares are available. Consider the likely commission costs and make sure the trade still makes sense.
Finally, as for getting out, I usually just put a limit order at my target price and just let it sit there. If my order isn’t getting hit, but the price is very close, I may change my order to exit on the shares that are showing on the Level II. Typically though, I just let the price come to me.
You will notice that a thinly traded requires more attention than a higher volume stock. With a high volume stock I usually just put out my orders and leave them alone because there is enough volume to typically fill my orders. A thinly traded stock requires more attention. You could place your orders and forget about them, but since there are so few participants, I have found that this often means many missed trades.
Final Word on Swing Trading Thin Stocks
There is nothing wrong with thinly traded stocks. I trade them regularly. I do prefer stocks that trade more volume, but if there is an opportunity in a low volume stock, I will take it. For traders who trade mostly US stocks, there is lots of opportunity in stocks that trade more than 500,000 shares per day. For traders in other markets, thinly traded stocks may be all you have access to. There are still lots of opportunities there. The charts look the same, the volume and bid/ask spread are just different. This requires a bit more finesse an attention when getting into and out of positions.
By Cory Mitchell, CMT