Tuesday, December 11, 2007

Protect Yourself from Thinly-Traded Stocks

In an earlier post I discussed how using a limit order to beat the spread doesn’t really reduce spread-related trading costs. Does this mean that investors should always use market orders when buying or selling stocks? Definitely not.

Let’s continue with the example of SPNS that had a quote of bid $1.45x200 and ask $1.60x2500, and we wanted to buy 6000 shares. In the earlier post we put in a limit order at $1.52. But there is a significant risk that this order won’t be filled. Maybe we really want to own this stock. (Please note that I don’t own SPNS, and I don’t know anything about it other than its quote worked well for my example.)

We could just put in a market order and see what happens. One possible result is that we get 2500 shares at $1.60, and the rest at $1.61. Great. We get all the shares we want at a reasonable price. But what if we get the first 2500 shares at $1.60 and then 500 at $1.70, 1000 at $1.95, and 2000 at $2.40? This works out to $11,600 when we expected to pay $9600 (plus commission).

One way to protect yourself when you really want the stock is to make a limit order at the current quote. So, if you placed a limit order to buy 6000 shares at $1.60 or lower, the first 2500 would be filled right away, and you could wait a while to see what happens. If the ask price rises to $1.61, you can change your order for the remaining shares to $1.61. But, if the ask price spikes up, you can just leave your order alone and be happy with the shares you did get.

When you are trading in a very liquid stock (where spreads are low and bid volumes are high compared to your order size), it's reasonable to make an order at the market. When buying a thinly-traded stock (with high spreads and low bid volumes), it’s a good idea to protect yourself with limit orders.

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