Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
How a stock’s liquidity can affect your returns
Most investors will be familiar with the charges associated with trading stocks and shares. However, a hidden cost which sometimes isn’t given sufficient prominence is the difference between the price at which you buy and sell a share, known as the bid/offer spread.
The bid price is the maximum price that a buyer is willing to pay for a share and the offer price (also called the ‘ask’ price) is the minimum price a seller is willing to receive.
Almost 100% of the time the bid price will be below the offer price. The size of the difference (also known as the spread) is largely a function of how liquid a stock is.
The liquidity of any asset essentially reflects how quickly an asset can be converted into ready cash and what impact this has on the price received.
CASH IN HAND
In real world terms cash in a current account can instantly be in your hands when you need it at essentially zero cost. A house is nowhere near as liquid by comparison.
It can take several months to go through the legal process involved with selling a house and if you’re looking for a quick sale this could have a materially negative impact on the price you get.
Shares as an asset class are fairly high up the liquidity scale because they are traded by thousands of other investors on the stock market.
However, there are significant variations. Most large cap stocks have a sufficient number of investors who are willing to buy and sell so liquidity isn’t an issue.
This means there is typically very little difference between the price at which you can buy and sell a stock. For example, the bid/offer spread on banking giant HSBC (HSBA) shares is just 0.1p and would have a negligible impact on your return.
Yet not all shares are as actively traded as HSBC, particularly those in small cap companies, and this is where market makers come in.
These are banks or stockbrokers who commit to trading shares and bonds to ensure you are always able to buy or sell a stock on an exchange in normal market hours (8am-4.30pm). There are 21 registered market makers with the London Stock Exchange.
BEWARE THE SPREAD
The bid/offer spread is effectively where a market maker makes its money and if there are lots of market makers in a share then competition will likely keep a lid on the spread. However, if there are just one or two market makers in a stock the spread can be wide.
Taking micro-cap mining firm Weatherly International (WTI:AIM) as an example, at the time of writing the bid price on the shares was 0.25p and the offer price at 0.3p – so the spread is 16.7%.
These figures imply you would pay 0.3p to buy the shares and get 0.25p if you tried to sell them – so theoretically you would have lost money as soon as your initial buy order is placed.
You would need the bid price to increase by 20% to 0.3p just to stand a chance of breaking even should you wish to sell.