Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Thinly Traded

What it is:

Thinly traded refers to an investor's inability to sell his or her investment at or near its value in a short amount of time.

How it works (Example):

Things that are thinly traded are essentially illiquid. Illiquidity is a factor of supply and demand for a security. But it is also affected by the size of the original issue of the security and the time since the original issue -- the smaller the number of securities out there or the longer the securities have been out there, the less liquid they tend to be.

Most people consider the size of the bid/ask spread as indicative of whether a security is thinly traded -- the larger the spread, the less liquid (and thus riskier) the security is.

Let’s assume you are watching Company XYZ stock. If the bid price is $50 and the ask price is $51.50, then the bid-ask spread is $0.50. This spread may be high or low depending on what the spread typically is for Company XYZ stock. An increasing spread denotes increasing illiquidity, and vice versa.

Why it Matters:

Larger bid/ask spreads (that is, thin trading) generally mean larger profits for dealers. Remember that one key aspect of bid and ask prices is that purchasers pay the ask price and sellers receive the bid price. This nuance is how securities dealers make a profit on bid-ask spreads: Their job is to buy stocks at the ask price and sell at the bid price. Thus, the size of the bid-ask spread is proportional to the size of the dealer’s profit (although not all of the spread constitutes profit for the dealer -- other fees are part of the spread).

Although the bid/ask spread makes the illiquidity of any investment relatively easy to measure, liquidity risk is harder to get a handle on -- that is, the chance that the spread will increase to a concerning size.

In the worst-case scenario, thin trading makes it possible that the investor could take a loss if he or she has to sell an investment quickly. But thinly traded securities can compound other problems for investors. For example, if the investor is unable to liquidate his or her position, this may keep him from meeting debt obligations (that is, the illiquidity increases the investor's credit risk). Buy-and-hold investors face fewer problems due to thin trading because they are generally not interested in buying and selling securities quickly. This is particularly true for buy-and-hold bond investors, who are simply waiting for their bonds to mature and are not concerned with interim price movements.