Trading low volume securities
Many of the stocks in 2CHYP are thinly traded. Much of the market would characterize this as a negative characteristic and it causes many to view these securities as riskier. This perceived risk will in turn cause low volume securities to trade at lower prices than they otherwise would, which makes a better entry point for long term holders.
While I agree that low liquidity is a risk, I find it more helpful to more precisely define that risk. Low liquidity presents a risk to those who either need to buy quickly or sell quickly. It becomes less of a risk for those who are in a situation that affords patience and it can even be an opportunity for those in a position to exploit it.
There are 2 forms of mispricing caused by low liquidity.
- Large bid/ask spreads
- Large trading range around market equilibrium
The first is rather straight forward and can be handled by simply using a limit order on the favorable side of the bid/ask spread and waiting for it to transact at your price.
The second is more complex and can best be described through an example. Let us imagine 2 stocks (one high volume and one low volume) that are each deemed by the market’s collective intelligence to be worth $10.00 a share.
The high trading volume stock would trade in a rather tight range around the equilibrant price of say $9.80 to $10.20. In contrast, the low trading volume stock would have a much wider range in which the price rapidly fluctuates; something like $8.50 to $11.50.
If one can ascertain what the market perceives the fair value to be, this volatile trading range can be exploited. By buying when a stock is at the low point within its trading range, it can be had at a higher dividend yield and better fundamental value that increases its expected return.
This is a somewhat subjective process and far from precise. There is nowhere in which one can look up the trading range, but in watching the markets constantly every day we get a sense for it.
Even with constant monitoring, it is easy to be wrong about a trading range, so we are careful to never base a trade solely on this. We only execute this trading strategy in a way that is fully backed by fundamentals. It is intended as a means of enhancing the returns of fundamentally sound stocks and, in my opinion, should not be used without fundamental backing.
The relevance of this to 2CHYP is that we have several stocks that we are looking to buy with the proceeds of the FPI sale earlier this week and are merely waiting for them to get in the opportunistic portion of their trading range. These stocks would be a good purchase at current pricing, in my opinion, but we think a better entry price can be had.