Low float stocks are favorites of day traders because the limited supply of these generally inexpensive shares can lead to exceptionally rapid changes in price. With the potential for great reward also comes the potential for great loss, however. The inherently risky nature of low float stock trading has led investors to learn to recognize key factors that can mitigate risk while leaving the door open for major profits. A financial advisor can help you determine if there’s a place in your portfolio for low float stocks.
The most common definition of a low float stock is any company that has fewer than 20 million shares available for the public to trade. The stock float figure is different and smaller than the number of shares outstanding. That’s because stock float excludes shares held by insiders and others that may be restricted from trading and, therefore, not available for public investors.
Relatively few companies fit this description of having low float. Many public companies have hundreds of millions, billions or even tens of billions of shares outstanding. For the majority, only a few percentage points of those outstanding shares are considered restricted.
Why Low Float Stocks Appeal
Trading in low float stocks aims to take advantage of the relationship between supply and demand. Because there are so few shares available, if a material event or significant news about a low float stock breaks, the shares can rise or fall in price very rapidly.
High volatility like this is exactly what day traders seek, because it gives them the ability to make quick profits. They can buy shares if they expect price appreciation, or short the stock by selling borrowed shares if they anticipate a price decline that will let them buy shares at a lower price before they have to be returned.
Some day traders may buy low float shares and hold them for only minutes before selling them again for a small profit. Because of the great volatility of low float stocks, a trader can generate a return of a few percent for each trade like this.
The most popular stocks for low float investing are so-called penny stocks, which generally includes stocks trading for under $5 per share. These stocks are found mostly on NASDAQ and the over-the-counter market.
Low Float Factors to Consider
Although appealing for its profit potential, low float trading is not without risk. Liquidity is one major factor to consider. Because there is a limited supply of these shares, a trader may have trouble buying shares when he or she wants to acquire them as well as finding a buyer when he or she needs to sell to lock in a profit. One way traders cope with the liquidity issue is to look for shares that, while having low float, also have high volume. When a sufficient number of shares are being traded daily, it increases the chances a trader can avoid getting stuck in a losing position due to lack of liquidity.
Another important element for a successful low float investment is the presence of some sort of catalyst. A catalyst may be a press release announcing a material event, a news story providing compelling insight into the company’s prospects or a strongly positive or negative analyst report. For example, announcing that the Food and Drug Administration had approved or declined to a drug made by a small biotech company would be a powerful catalyst.
The catalyst will focus investor attention on the stock and, as investors try to buy or sell shares, the limited supply of them will apply great leverage to the stock price. Because many low float stocks are targeted by traders who are looking for quick profits, the shares may rise sharply and then fall again just as quickly as traders sell to lock in profits.
Traders generally do not seek to own shares of low float stocks long term. In fact, they are likely to close out their positions every day, rather than take the risk that a catalyst or surge or profit-taking will occur overnight and cause the stock to rise or fall quickly, which could cause a rapid and large loss.
Share prices of low float stocks can rise and fall much more rapidly than those of companies with lots of shares available for the public to trade. This effect of the law of supply and demand makes low float stocks popular with day traders, who aim to make money off fast, short-lived movements in share prices. To counter the potential risks, which are approximately equal to the prospects of reward, traders look for significant volume and the pending arrival of some important catalyst to prompt the stock to move.
Tips for Investing
- Before putting significant money into a low float stock, it is prudent to discuss the planned investment with an experienced financial advisor. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Once you’ve decided to start investing your money, you’ll have to decide on an asset allocation that’s appropriate for your goals, age and risk tolerance. And unless you invest in a target date fund that automatically adjusts that asset allocation, you’ll have to rebalance your assets over the course of your investing time frame. That’s where an asset allocation calculator can save you a great deal of time.
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