June 11, 2007

In this week's free newsletter, we'll look at  Risks of Trading Low-Volume Stocks.

I don't run a talent agency, but a big part of my nightly routine is based on finding stocks which have the right look.  But as shallow as that sounds, it's not only about looks!

Although I'm a big proponent of trading from the chart patterns, a stock's volume simply cannot be ignored.  Here at TheStockBandit.com, we scan hundreds and hundreds of stocks every night in search of not only the best technical setups, but also the proper conditions under which to trade those stocks.  We ultimately locate the cream of the crop for our members, and it results in consistently profitable trading.

However, there are many stocks which come through the scans with "the right look" to them, but a closer examination reveals some glaring reasons to avoid the stock as a potential trade.  The most common reason pertains to volume, and particularly the risks associated with low volume.

Volume is the total number of shares traded for a given timeframe.  It's a measure of liquidity for a stock, because it represents participation.  High volume makes for a more competitive market with narrower spreads and more consistent price action.  Extremely low volume, however, is a warning sign to move on to the next trading idea.

Low Volume = Stay Away

Low volume means low participation.  If very few people are active in a stock, then what appeal does the stock have to a trader?  If participation remains low, that stock may simply sit idle while you have your cash parked in it, leaving you with few opportunities for profits.

Additionally, a stock with very low volume will often trade with a wide spread, which increases slippage when entering and exiting trades.  Trading is hard enough without handicapping yourself with inferior executions!

It is also far more difficult to accurately read the price action in a stock which might only be traded every 10 to 15 minutes during the day.  When a stock only trades 25,000 shares a day, what defines a large seller?  2000 shares?  What defines momentum?  A 20-cent move?  It isn't worth it.

And finally, a low-volume stock can be awfully difficult to get out of when the tide turns against you and you need out.  When the music stops and you need a chair, it's going to be extremely competitive to get a good price when you go to sell your stock, which makes your losing trades even worse when they happen.

Looks Aren't Everything!

Let's look at an example.  ASY showed up last night on my scans as having "the right look" to it.  However, one glance at volume was all it took to see that this stock is too thinly traded for my liking.  This stock averages fewer than 25,000 shares per day, which is entirely too light no matter how good the chart pattern might be.

TCNet chart courtesy of Worden Brothers, Inc.

ASY has a very nice bull pennant pattern which can easily be seen with the converging trend lines on the chart shown above, but this stock has hardly anyone trading it!  This stock may take off and run higher, but the risk associated with the incredibly light volume of this stock says we're probably better off finding something more liquid to trade.

When you screen for chart patterns, be sure to include volume in your requirements for potential trades.  Just because the chart looks pretty or the pattern is clean doesn't mean the stock should be traded.  With literally thousands of stocks out there to trade, be strict with your criteria and put the odds in your favor every chance you get.

Or start your membership at TheStockBandit.com and we'll do it for you! 

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Jeff White
President, The Stock Bandit, Inc.
www.TheStockBandit.com

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