Illiquid stocks are difficult to buy or sell because they have limited trading activity, fewer buyers and sellers, and wider bid-ask spreads.
A stock can look attractive simply because its price suddenly jumps or its trading volume shoots up. When a stock normally has very little trading activity, a sudden spike deserves a closer look.
Illiquid stocks can be difficult to exit, and unusual trading in such stocks has also been linked to market manipulation.
Here is how to identify and trade these stocks that are vulnerable to price manipulation and other fraudulent trading practices.
Key Takeaways
- Illiquid stocks have limited trading activity, fewer market participants, and often wider bid-ask spreads.
- A security can be classified as illiquid when its average daily turnover is below ₹2 lakh for the previous two quarters and it is classified as illiquid on all exchanges where it trades.
- Reversal and synchronized trades can create artificial volumes and give a misleading impression of genuine market activity.
- A sudden rise in the price or volume of an illiquid stock does not automatically mean that investor interest has increased for valid reasons.
- SEBI and stock exchanges monitor suspicious trading patterns, while trading platforms may place additional restrictions on illiquid securities.
What are Illiquid Stocks?
Illiquid stocks are shares that cannot be easily bought or sold without affecting their price. The problem is usually a lack of active buyers and sellers.
A stock may be considered illiquid when it has:
- Low trading activity
- Limited market depth
- A wide difference between the bid and ask price
- Very few interested buyers or sellers
- Difficulty in finding a buyer when you want to exit
This matters because owning a stock is only one part of investing. You also need to be able to sell it when required. With a liquid stock, there are usually enough buyers and sellers to make this possible. With an illiquid stock, even a relatively small order can move the market price sharply.
For example, suppose an investor wants to sell 500 shares of a large and thinly traded small-cap stock each. Here’s how his experience might look like:
| Large, actively traded company | Thinly traded small-cap stock |
| Investor wants to sell 500 shares. | Investor wants to sell 500 shares. |
| Thousands of shares are traded every minute. | Only a few hundred shares may trade on an average day. |
| The order is usually filled almost instantly. | The order may not find an immediate buyer. |
| The investor can usually sell at or near the current market price. | The investor may have to wait or accept a lower price to sell. |
How are Stocks Classified as Illiquid?
Stock exchanges use specific criteria to identify illiquid securities.
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It normally trades in the market and is not under trade-to-trade settlement.
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Its average daily turnover is less than ₹2 lakh, calculated over the previous two quarters.
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The stock is classified as illiquid on every stock exchange where it is traded.
Even if a stock meets the above criteria, it will not be classified as illiquid if any one of these conditions applies:
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Its average market capitalisation is more than ₹10 crore.
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The company has paid dividends in at least 2 of the last 3 years.
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The company has been profitable in at least 2 of the last 3 years, and:
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Not more than 20% of the promoters' shares are pledged in the latest quarter
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The company's book value is at least 3 times its face value.
Source: https://www.nseindia.com/static/products-services/equity-market-periodic-call-auction
The classification is important because low trading activity can make a stock more vulnerable to unusual price movements and trading practices. Investors can check the lists of illiquid securities published by the relevant exchanges.
Why are Illiquid Stocks Difficult to Trade?
The biggest issue is simple: there may not be enough people on the other side of your trade.
Suppose a stock is trading at ₹100, but there are very few buyers.
You may place an order expecting to sell around ₹100, only to find that the available buyers are quoting ₹95 or even lower. If you need to sell quickly, accepting the lower price may be the only practical option. The same problem can occur when buying.
A wide bid-ask spread means the highest price a buyer is willing to pay and the lowest price a seller is willing to accept are far apart. Limited market depth can make this problem worse.
As a result, a relatively small transaction can cause a noticeable change in the quoted price.
How Can Trading in Illiquid Stocks Become Risky?
There are two different risks that are easy to mix up:
| Normal illiquidity risk | Manipulation risk |
| Happens because there are fewer buyers and sellers. | Happens when someone deliberately tries to mislead the market. |
| You may have to sell at a lower price or wait longer to find a buyer. | Traders may use activities like reversal or synchronised trades to create fake volume or move the price. |
| Bid-ask spreads can be wider. | The price or trading volume may be artificially influenced. |
| It does not mean anyone is doing anything wrong. | It involves deliberate actions intended to distort what other investors see. |
So, not every illiquid stock is being manipulated. Illiquidity is simply a condition where there are fewer buyers and sellers. However, because trading is thin, it can sometimes make manipulation easier to carry out and harder to spot.
Illiquidity itself is a risk, but the problem becomes more serious when unusual trading activity starts influencing the price.
A stock that normally trades in small quantities may suddenly show a sharp increase in volume. Its price may also move significantly within a short period.
For example, a stock that normally trades in very small quantities may suddenly see a big jump in trading volume, along with a sharp rise or fall in its price. To an investor watching the market, this might look like the stock is suddenly becoming popular. But high volume does not automatically mean genuine investor interest.
This is one reason unusual activity in thinly traded securities attracts regulatory attention.
What is Reversal Trading in Illiquid Stocks?
Reversal trading involves buying and selling securities between the same or connected parties in a way that creates artificial trading activity.
Instead of trades reflecting genuine demand and supply, the transactions are structured to produce a particular result.
For example, two parties may take opposite positions and arrange trades that are later reversed. The transactions can make the security appear to have much more activity than it actually does.
This can mislead other market participants. Someone looking at the trading screen may see higher volumes and assume that many independent investors are actively buying and selling the security. That is why unusually high activity in an otherwise illiquid stock needs to be treated carefully.
How Does Market Manipulation Happen in Illiquid Stocks?
In simple terms, the process usually unfolds in a few steps:
- Step 1: Create the Price Move
A trader buys or sells a large amount of a thinly traded stock. Because there are not many orders, this can move the price significantly. - Step 2: Attract Other Investors
Other investors see the price movement and may assume that there is genuine buying or selling interest. They then start following the move. - Step 3: Push the Price Further
As more investors join in, the price moves even further in the same direction. This makes the stock appear even more active and popular. - Step 4: Exit at a Better Price
The original trader then sells at the higher price created by the buying they helped trigger. Alternatively, if they had sold first, they can buy back at the lower price after the decline.
In both cases, the trader may make a profit while other investors end up trading based on a misleading market signal. This makes illiquid stocks more open to manipulation. It is easier to manipulate a security when there is very little actual trading in it. If only a few orders are available, coordinated trades can have a big impact on the displayed price and volume.
What Signs Should Investors Look For?
From a single signal, it is impossible to tell whether trading is genuine. Nevertheless, some patterns are worth noting.
Look for:
- When a stock which usually has very low trading activity suddenly exhibits a great deal of volume, it merits further investigation.
- Sharp changes in price: A large change in price without a clear business or market explanation can be a warning sign.
- The bid-ask spread is wide: There is a big difference between the price at which something can be bought and the price at which it can be sold, which shows that there is little liquidity.
- Because of the low market depth, the stock is more susceptible to price fluctuations since there are very few buy and sell orders.
- Strange trading patterns: When transactions occur repeatedly or in sync, this might point to activity which is not in keeping with normal market demand.
No single one of these signs constitutes proof of manipulation; they only indicate that the stock should be subject to further scrutiny before a trade is made.
What Actions are Taken to Combat Fraudulent Trading?
SEBI keeps an eye on any suspicious activity in accordance with the Prevention of Fraudulent and Unfair Trade Practices relating to Securities Markets Regulations of 2003.
If unusual patterns appear when trading in an illiquid security, SEBI has the authority to carry out an inquiry and take action once violations have been established. Stock exchanges require trading members to carry out extra due diligence in the case of transactions in illiquid securities.
Exchanges have the possibility of examining suspicious transactions and can impose penalties in certain cases. They also publish circulars and other communications to warn investors against trading in listed illiquid securities.
The aim of these measures is to reduce the possibility of artificial trading and to safeguard the integrity of the market.
What Rules Can Limit Trading of Illiquid Stocks?
The trading restrictions will depend on the particular security, the exchange, and the broker.
- Margin restrictions: Brokers may apply higher margin requirements, or restrict intraday and leveraged trading, on stocks classified as illiquid, since a small order can move the price sharply.
- Surveillance measures: Illiquid securities identified by the exchanges are often moved into a Periodic Call Auction mechanism. Here, orders are matched at fixed intervals rather than continuously, which changes how quickly an order gets executed.
- Product availability: Some brokers restrict or disable certain order types (such as market orders) for illiquid or trade-for-trade category stocks, and futures and options contracts on such underlying stocks may be limited or unavailable altogether.
What Should Investors Look at Before Trading an Illiquid Stock?
Before you place an order, make sure that the stock has sufficient genuine trading activity to back up the transaction you intend to carry out.
A few basic checks can help:
- Look at the trading volume: Instead of considering the figure from one day, you should compare the current volume with the stock's usual level of activity.
- If you look at the bid-ask spread, a wide spread will increase the cost of getting in or out.
- Look at the market depth to see the number of buy and sell orders that are actually there.
- To work out why the price has moved, you should look for a real company announcement or some development in the market following a sudden increase.
- Be careful when dealing with a sudden increase in volume since such an increase does not always indicate strong underlying demand.
- Make sure you know the trading restrictions: Verify if the security has any limitations concerning intraday, margin, or derivative trading.
Conclusion
Since illiquid stocks need more attention, it is only part of the problem to enter a position. It is much harder to exit it at a reasonable price.
It can be difficult to trade these securities because of low trading volumes, narrow market depth, and wide bid-ask spreads. Moreover, unusually active trading in an illiquid stock may at times be connected with artificial volumes or other manipulative practices.
Investors ought to go beyond a sharp rise in price or a sudden increase in volume. By understanding the stock's usual trading activity, by checking the market depth that is available, and by remaining alert to any unusual patterns, they can help lower the chance of being caught in a manipulated trade.
