Why avoid low priced shares?

Some traders avoid positioning their portfolios in shares that trade below a certain value threshold, generally $1.00 or less. (In the U.S. stock market, that figure is usually $10.00 per share or less.) Although this may seem arbitrary, there’s some sound reasoning behind the decision, which is actually based less upon the share price than on the company’s market capitalisation.

Lower priced shares tend to be associated with micro or small cap companies, those with market capitalisation below $1 billion. At that level of trading, liquidity will not be particularly deep, e.g., there’s not an overabundance of buyers or sellers seeking to move the shares about:
•    The smallest cap companies, called nano caps, may transact only 1,000 to 5,000 shares each day.
•    In comparison, Billabong International (BBG), even on its slowest trading day, moves roughly 250,000 shares between buyers and sellers.

The problem arises when purchasing a small cap stock and is repeated when exiting the position:
•    When a trader seeks to purchase shares of a small cap stock, because there are few sellers willing to sell he must pay whatever price they request, which is likely to be higher or significantly higher than the price he wished to pay. If he holds out for a better price, he may never enter the position at all.
•    When the trader seeks to sell, again, there are few buyers and the price they’re offerring isn’t likely to be as high as the one he’d prefer. If he holds out for his preferred price, he may find himself holding that position open for a long time.

As well, small cap stocks are vulnerable to market manipulations. Some unscrupulous traders, stuck in a position they regret opening or seeking to profit from a massive intraday move, start rumours on chat forums, social media, or through email, claiming the company is on the brink of launching a revolutionary new product or is teetering on the verge of bankruptcy.

Rumours of that ilk tend to be ignored or shrugged off by large cap or even medium cap stocks, which are understood (or presumed) by market participants to be financially sound and reasonably transparent with their development plans, etc.

But for small, micro, and nano cap companies, the resulting moves can be deadly, causing gains or losses of greater than 10% in the day’s trading, only to be reversed the next day by frantic traders seeking to correct their hasty mistake. Meanwhile, the trader who started the rumour was able to either purchase the stock at a fraction of its previous price, or exit an open position with a larger profit than he could have otherwise gotten.

As a general rule of thumb, if a company trades fewer than 50,000 to 100,000 shares on an average day, the shares are too illiquid for trading safety.