The Importance of Liquidity in Smaller-Cap Stocks

By liquidity we mean how many shares the stock trades per day. Liquidity is determined by a number of factors: the number of shares in the float, or the number of shares held by the public that can be bought and sold. Typically, most companies do not have all of their shares outstanding in the public float; shares could be locked up from financings, or a percentage may be held by insiders. Most stockbrokers will advise you not to buy a stock that is not “liquid.” Most big cap stocks trade between 2% and 5% of their float per day. Some of the smartest microcap fund managers say that they “like to buy stocks before they are liquid, before anyone else finds out about them.” The reason is simple: by the time everyone else understands and appreciates the value proposition of the company, the stock will theoretically have started trading near or at its true value.

Factors affecting liquidity:

By way of example, if stock xyz is trading at $2.80, and a potential seller will not sell below $3.50, and he owns a controlling block or a relatively large percentage of the float, this factor alone could inhibit trading in the stock.