What are Illiquid Stocks?
Illiquid stocks are high-risk stocks and are challenging to sell because of the expense, lack of interested buyers, and other factors. Examples of illiquid assets include real estate, stocks with low trading volume, or collectibles. Illiquid assets still have value and, in many cases, very high cost, but are challenging to sell. Investors cannot find ready buyers because of the limited trading of illiquid stocks.
Illiquid stocks have lower trading volumes with limited investors. Generally, they include small stocks which cannot be realised quickly. Now that you know what is an illiquid stock let’s find out how you can identify one.
Examples of Liquid and Illiquid Assets
Immovable properties such as homes, offices, factories, vehicles, antiquities, debt instruments, and private business holdings are examples of illiquid assets. Illiquid assets also include certain artworks and collectables. Comparing equities traded over-the-counter (OTC) to those on exchanges, OTC trading is less liquid. Despite their considerable worth, fewer people are purchasing these stocks.
In a business context, illiquidity describes a situation where a company lacks the necessary cash flow to meet debt obligations, despite owning assets. During bankruptcy, the company may need to sell valuable assets like land, machinery, or production equipment. However, such assets can be challenging to sell quickly, often leading to distress sales at lower prices than their actual value.
Conversely, securities such as stocks, ETFs, mutual funds, bonds, and exchange-listed commodities are highly liquid assets. They can be readily bought or sold at market prices during regular trading hours. Precious metals also offer liquidity, allowing for swift transactions at market rates.
Between these extremes lie assets whose liquidity may fluctuate over time due to external market factors. For instance, collectables’ prices may vary based on shifts in market demand and popularity.
How to identify illiquid stocks?
1. If institutional investors show less interest in stock; it is a sign of low performance in terms of return.
2. If the stock does not have enough trading volume daily, the chances are that the stock is going to be illiquid.
3. If the stock is hitting lower value regularly, it is an indication of illiquid stock.
4. If there is a massive difference between the bid price and the asking price, the chances are that the stock is illiquid.
Illiquid stocks are the ones that have negligible trading and cannot be sold immediately. Illiquid assets give a higher yield but are hard to sell as compares to liquid assets. Even if there is a quick sale, it may not be without a substantial loss in value.
These assets and securities cannot be readily converted into cash. Another reason why illiquid assets may be hard to sell is that there is a low trading activity or interest in the stock, indicated by a lack of ready and willing investors to purchase the stock. As a result, illiquid stocks might have lower trading volume, wider bid-ask spreads, and higher price volatility.
Illiquidity for a business refers to a company that does not have the cash flows necessary to make its required debt payments. Real estate, capital assets have great value but are not quickly sold when cash is required.
In case of unforeseen circumstances or emergency crisis, a company may need to liquidate these assets to avoid bankruptcy. If this happens quickly, it can dispose of assets at prices far below an orderly fair market price.
How do I Buy Illiquid Stocks?
By taking the following safety measures, one can purchase illiquid equities.
- Stocks must be purchased according to the limit order set by the investor. The maximum and minimum restrictions must be adhered to by the broker while buying or selling.
- Buy stocks in predetermined quantities to prevent large allocations that may be difficult to sell later.
- Ensure commission does not surpass 1% of the transaction value to maintain profitability.
- Determine fixed stock values instead of engaging in bidding processes to prevent overpayment.
- To facilitate smooth transactions, choose stocks that can be easily sold by small investors.
Conclusion
Illiquid stocks have the potential to do well in the long run. Similarly, there is also a danger involved with them. As a result, having a plan prepared for investing in illiquid equities is crucial, contingent on the investor’s long-term goals and risk tolerance.
A smart investor will recognise illiquid stocks with strong long-term potential gains. Before making an investment in them, they will conduct the necessary research and finance a little portion of their portfolio, the loss from which they can afford to bear.
At Angel One, we strive to give individuals the best research and online calculator tools to help them make the right stock-market decisions. In this way, retail investors can avoid illiquid stocks in their portfolio or hold off on selling them too quickly. Open your demat account with Angel One to start investing.
FAQs
How unsafe is purchasing illiquid stocks?
It is impossible to sell illiquid equities quickly due to their restricted trading. Because of this, purchasing them presents a greater risk to the investor.
Who can purchase illiquid stocks?
Illiquid equities are normally avoided by institutional investors, however they can be purchased by those with a longer investment horizon and a high tolerance for risk.
Do illiquid stocks have more volatility?
Compared to liquid equities, illiquid stocks are more volatile. An illiquid stock’s large price differential between its ask and bid prices is one of the main causes of its volatility.
