Small Cap Liquidity Explained

A small cap stock is of no value if you can’t get in and out of it as you desire. Imagine you’ve found the stock of a lifetime. You buy it, the stock goes up and now you’re stuck trying to get out. This is a scenario that happens to a lot of small cap players who aren’t careful.

Liquid Motion

The issue at hand is stock liquidity. It’s either there for you or it isn’t. The same stock could be highly liquid for one small cap investor and not even close for the next.

What is liquidity? The liquidity level of a stock is determined by your ease or difficulty in moving positions. The liquidity directly corresponds to the trading volume of any given day.

Rule of thumb. If you’re going to need a high level of liquidity—perhaps you’re trading in and out of a stock—you should keep your stock position totally no more than 1% of the stock’s average daily trading volume. If you’re willing to stick around, you can increase this number.

Small cap bad example. Let’s say there’s a small cap stock trading at $3 per share and you’re ready to buy 20,000 shares. At some point later it spikes up to $4 per share and you want to exit your position. But, there’s a problem. The stock is only moving 200,000 shares daily. Given your stock position, you represent 10% of the stock—not good.

Small cap good example. You found a great small cap stock that’s trading at $12 per share. You buy 10,000 shares. Soon after it spikes to $15 and you want to sell of your entire position. Because the stock is trading 2,000,000 shares daily, you have no problem executing your trade.

Before you jump into any small cap stock, always take a look at what your liquidity is likely to be. If you’re over the 1% mark, you may want to scale back your investing for that stock or look elsewhere.