Why do Penny Stocks and USA Shares have Wider Spreads?

Q. So I can actually spreadbet AIM and SMALL CAP shares right?


A: Yes, IG Index will quote smaller companies with a market capitalisation of £10 and over (other firms may not quote companies of markets caps lower than £50 or £100 million. Beware though, that the spreads might be significant as the liquidity in such shares tends to be low. Also, as I've stated the smaller the company, the less liquid the shares, so you may have to put up a margin deposit of 25% to 50% for such stocks. Lastly, trading in smaller and less liquid shares is more likely to tie up capital for long periods of time which you as a spreadbettor most probably would like to avoid (since it raises the issue of opportunity cost). This is another reason why trading (as opposed to investing) in small cap shares may not be a good idea; especially if the price doesn't move much.

Note: The primary CFD and spread firms have learnt via massive hits to their balance sheets in 08/09 that offering illiquid small caps on margin simply is not wise. If you found a firm that is still doing so (and accepting big sizes) then frankly it is cause for concern. Basic common sense is to not gear up on this type of play.

Q. I have noticed that some shares on AIM and SMALL CAP have a very wide SPREAD (about 50%)...

I have noticed some shares on AIM and SMALL CAP have a very wide SPREAD (about 50%) and some are only (about 2%) especially on 10-20p shares. Can you explain to me exactly what causes this or is it a combination of things?

A: Simple explanation, AIM stocks, are commonly referred to as penny stocks i.e., they are cheap in comparison to Mid Caps, Large Caps (i.e. FTSE listed securities)...etc, and since in a market place you need to have a buyer, a seller, and a middle man who are known as a Market Makers (MM), but are not liked by most as they have the power to dictate at what point they will buy and sell you the shares...

To get this into perspective take a look at for instance £4.5 million cap coal-to-liquids specialist Spitfire Oil (SRO:AIM). It would appear that Spitfire Oil's shares trade at 10.5p but the offer price (the actual price you will have to pay) is 16p, while the bid price (the level at which you can sell the shares) is 5p. This equates to a 320% spread and means shares would have to go up by the same proportion, to a mid price of 33.6p, just for the investor to break even.

The MM's don't want your shares hence the massive spreads. The reason why some AIM stocks have massive spreads is liquidity, in that the Market Makers do not believe they can easily sell the shares as quick, so if there is only a small percentage in free float then this becomes a problem for the MM to sell the shares on, so in order to buy your shares the market maker will usually issue insane spreads so to take the chance that they can sell them on, if you look at other AIM stocks that have good liquidity, you can see very small spreads, MXP,SLN,RXP, as the MM knows there is massive demand and so can easily buy and sell these on. So to recap, AIM shares often have a very thin market - sometimes no trades in a day, sometimes 4 or 5 trades. This means that there is almost always a wide spread between bid and offer prices.

The Market Makers make their money from the spread so it's better to deal in good liquid AIM stocks, as the spreads are very low compared to others, unless you really believe in the share you are buying and then you should be looking very long term, maybe 2-4 years, hopefully there will be more shares coming to the market to help liquidity, problem with iliquid stocks is that they can be prone to wild fluctuations because the free float is small, IMO always look at the spread in every share.

Usually small companies are almost exclusively traded by private investors as opposed to institutions; with smaller caps the liquidity is restrictive for big investors because they simply cannot buy a big enough portion of the company. Of course once a small cap stock starts moving it can move very quickly due partly to the low liquidity, a smaller order book and a thinner market and any big orders are likely to push market makers to change bid/offer prices quickly to tempt clients to trade. So on the one hand this opens up the possibility of substantial gains over a very short period of it but on the downside it can be difficult to dispose of a sizable position (without heavy losses) if you want to exit quickly as your order is likely to impact the share's price. In some extreme cases I've seen cases where investors bought into a small cap but because it was completely illiquid they found it impossible to sell it again.

So by their very nature AIM shares are risky reward plays, some can be a ten bagger, or can go bust, so pay your money and take your chance, thorough research is what counts, look for potential growth, possible low forward PE less than 12, revenue increasing YOY, these are likely to become winners but as ever things change so there is no such things as a sure fire winner. Such companies are very difficult for the small private investors to research - the key here is to talk to executives on the phone or even better meet their management to get a 'feel' of the company. If you don't like the risk/reward, my advice would be to stick to small caps that are listed and are growing in development areas, again the bigger picture needs looking into, as ever DYOR, never take on someone else tips without looking into your own work - it's your money! And keep in mind that AIM stocks tend to go down far more quickly than they rise!!

Q. Why is a spread on a USA stock sometimes much wider than that of a UK stock?

A: Stocks traded on USA exchanges are more volatile than those traded on the London Stock Exchange. For this reason the spread betting providers who quote USA stocks may offer them at a wider bid-offer spread or insist on higher margins. This is a way for bookies to discourage traders taking positions on very volatile or heavily trending stocks.

Q. I took a position in STP, after a recent good 1/2 year report and a new acquisition, I have tried to buy more but now cannot buy online...

the MMs have a spread of 15% on a 60p share,is this normal or have I made a mistake getting into this in the first place?

A: I'm afraid this can be normal for small cap shares which tend to be illiquid (in fact market makers may only offer 1000 to buy and sell before choosing to move the price). You haven't made a mistake if you believe the price of STP stock will rise...but buying more would be expensive with that spread (and thus probably unwise to do so).

Q. Do you ever use a 30 min chart to trade FTSE?

A: Response by expert chartist Henry -:

It doesn't matter what timeframe you use but be aware that shorter timeframes should have a much shorter distance to your stop so therefore represent less risk to your account. Because of 'noise' caused by computer trading, longer timeframes give more reliable trades but fewer of them. Not a quick or easy game to find out what is best for you imo. Most end up losing long term with very short-term trading. Similar with equities, the biggest risk is in very small cap shares with wide spreads (10% quite common). The least risk is in trading FTSE 100 stocks with spreads as small as 0.5%. Easy to get in and out of FTSE 100 stocks and much quicker and cheaper than small caps. They also tend to trade a more reliable pattern. Small caps give bigger rewards but cost you more in terms of risk.

 ...Continues here - How the Dividends are Accounted for in Spread Betting

Recommend this on Google

The content of this site is copyright 2016 Financial Spread Betting Ltd. Please contact us if you wish to reproduce any of it.