Spread Betting AIM Stocks and Penny Stocks

Q. What is AIM?


A: AIM stands for the Alternative Investment Market, an exchange regulated market also run by the London Stock Exchange home to about 1,200 companies, most of which with a market capitalisation lower than £50 million. AIM allows growing companies access to finance with fewer restrictions in terms of companies' trading history, financial track record and liquidity of the shares. Note that companies trading on AIM are likely to be highly volatile with big gaps (even up to 10% or more) in the bid-offer spreads. However, the big risk with trading small cap stocks is that if the liquidity dries up it can become really expensive to trade (as was the case with most AIM-listed shares in the first quarter of 2009). Note that the spread tends to be narrower for AIM stocks that have more market makers dealing in them. If trading in bigger sizes or trying to deal in a stock with a wide bid-offer spread it is usually worth the effort to phone your broker's dealing desk as they might be able to negotiate a better deal on your behalf.

So what are the differences between AIM and the main market for the companies?

The main market
  1. 25% of your shares must be held by the public
  2. Three-year trading record required
  3. Shareholder approval required for various transactions
  4. Application vetted by the Stock Exchange
  5. Minimum market capitalisation requirement
  1. No minimum shares to be held by the public
  2. No trading record required
  3. Less onerous requirements for shareholder approval
  4. Application not vetted by the Stock Exchange
  5. No minimum market capitalisation requirement

Trading smaller caps and AIM shares can offer the potential of bigger returns, but it does come with increased risks and higher costs. Traditionally, over an extended period of time smaller companies tend to outperform their larger counter-parts, however in times of economic turmoil they will underperform, not least because they tend to suffer due to liquidity issues. My strategy for high risk stocks which includes all Aim stocks is a low stake and wide stops. As the volatility on Aim is much higher than say FTSE 250 stocks it figures that on Aim you need the courage of your convictions on research and a lesser focus on current price and techncial analysis. I also avoid free investor boards like the plague - I never go on them now.

Previous analysis of mistakes has shown me that low cap stocks like one often finds on the Alternative Investment Market are very difficult to get right. So I now tend to stay away from them and if I am tempted I only commit a small amount of capital, an amount that I can lose and not worry about. Sure this limits my upside, but more importantly it limits my downside.

Note: The AIM market exists to provide a simple, quick and efficient means for companies to raise capital and operate in a lighter regulated market than would be possible with a full listing. Companies listed on AIM usually have a lower profile and thus get less reporting coverage from brokers and analysts, so there is more scope of finding hidden gems. The investor in an AIM listed company is always making a trade off between the risks of investing in a lighter regulated market (for instance a higher risk of corporate management problems or fraud), with and the potential for substantial gains due to the valuation anomalies that exist in companies that have minimal (if any) research coverage. Small caps are typically under followed and under researched since the big institutions and brokers may only have a limited interest in them. This also means that these companies may struggle to reach a valuation commensurate with their growth prospects and may trade on the stock market at a discount to their underlying value. But of course the reality is that AIM's a bit of a casino, and research can only take you so far in eliminating the risk.

Recently, I've been reading a paper looking at the failure rate of AIM listed stocks. It's a bit confusing because it includes takeovers as a reason for failure in some cases, but if you break this out it finds that 32% of AIM listed stocks fail within 5 years for negative reasons (i.e. not due to mergers or acquisition), that this varies little across industry and that stocks issued during 'hot markets' have a lower survival rate. They also show that survival rates increase with increasing company age at IPO, increasing market cap at IPO, increasing % of stock listed at IPO and the reputation of the NOMAD.

Is the AIM market a leading indicator for the main market? I think it is because AIM is traded mostly by small private investors who are trading their own money so tend to be quicker to react to events. The AIM index seems far more responsive, as the investors are more mobile. The FTSE shares being held by pension funds and index funds these days can make it a different animal altogether. The spread and the illiquidity also, make the smaller shares far more responsive when the tide turns. I don't know if I'd put it down to personal investors being more savvy, but definitely more mobile. It could be that the AIM market is actually more easily spooked so people get out earlier and more heavily than the main market. If you were to look at your portfolio and think which shares do I want to dump first, would it be the riskier AIM shares?

Be wary of investing in small Pharmaceuticals. The market is literally littered with failures. A good example being Alizyme AZM which was considered to have three or four potential blockbusters in late stage trials, any of which would have been a company maker. Sadly despite the hype none of them came good and the company was wound up in 2010.

Q. I'm fairly new to investing and am trying to find a website that will allow me to go short on the AIM. Any ideas?

A: Most spread firms will let you take out shorts on the biggest AIM stocks - mainly the top 50. They will all only take bets over the phone rather than on the net though!

Finspreads quotes spread bets on UK stocks down to a market cap of £50 million although it will go lower if there is sufficient demand. Be warned however that illiquid stocks are prone to wild jumps and although stop losses are available to limit the risks, the prices on really small stocks could easily get past these.

Q. Why do some some shares go in to auction during the day?

e.g. Next (NXT) was in auction during midday on one trading day. Why does this happen and and what causes it to happen?

A: Yes, a share automatically goes to auction for 5 minutes if it has moved by more than 10% (I think) - the idea is to stabilize the price a bit. It then comes out of auction and would go back in on any other big moves. It happened a lot with the banks this year as they were so volatile. Small cap stocks all go into automatic auction for 5 minutes at 11am and 3pm.

Q. So is it possible to trade penny stocks and options derivatives using spread betting?

A: Yes, IG Index will quote any penny share or AIM stock with a minimum market capitalisation of over £10 million although other providers may not offer prices on stocks with market caps of less than £50 million or £100 million. Of course, the smaller the company the less liquid the shares, so you may have to put up a margin percentage equivalent to 25% to 50% for such stocks.

Most UK shares are electronically traded but on AIM shares are still traded using market makers which normally means lower liquidity and wider spreads than their larger peers. In practice it is hard to trade small caps short-term since the market maker spreads on penny stocks tend to be quite wide and ideally you would want to trade inside the spread and also because of the potential spikes in price caused by wide variations in liquidity. This is especially so when there are fewer market makers in a stock. With spread betting the spread is even wider with no possibility to trade inside the spread (since providers take the market maker quote and add a bit to the bid-offer market maker spread). Thus, since trading in small companies is difficult because of the wider spreads, in such cases you would do well to aim to trade medium term moves lasting a number of weeks as opposed to days.

A good idea is to calculate the spread of the instrument you wish to bet on as a percentage of the price. For instance I'm looking at GVC.L which is a relatively small stock with a valuation of some 70 million. The underlying market currently has a spread of 223-226 (1.33%) while the price I was quoted by my spread betting provider was 222.6-226.4 (1.68%). If one compares this to a stock like BP which is in the FTSE 100, the underlying market spread for BP is presently 0.04% while the spread betting provider's quote is 0.2% of price. The point here is that smaller caps come heavier in commission terms so it is harder to make money trading off them.

Note: You can also trade index options and futures at IG Index but not stock options (but anyway spread betting on a stock is similar to an option).

Q. I've just tried to open up another spread bet on PCI via IG only to be told that the 'market is only open for closing deals' when attempting the transaction online!

After calling them, I was informed that they have a maximum limit for the stock, over which they have to telephone the broker directly - It therefore looks like lots of bets have been placed with them and they are now at their limit! (he didn't say what the limit was unfortunately!)

A: IG Index will sometimes do this if the shares are illiquid. I assume they have a risk limit for PCI and it has now been reached. It seems that once the limit is reached, they are no longer willing to take the risk without actually purchasing real shares which would offset their risk.

A thing which may be of interest is that a lot of the stops on AIM shares are triggered manually by IG staff, so If you have a non-guaranteed stop it may take a while to kick in, as someone has to click a button, and so not get your stop price. Also, some buy orders which are for more than a few thousands of AIM shares also get referred to a person.... so your order on the IG screen asks you to wait (for the person to accept your order manually), even though you did it on the internet. If your stops kicks in at 8:10am you may find the staff member is 'not at work yet' and so the stop fails to trigger... true!!!

Q. CGT changes and AIM shares

As I understand it, the proposed changes to CGT will affect AIM shares by making gains from them taxable at the same rate as for other shares. If its right though, does this mean that in future AIM shares could be included within ISAs?

A: I believe AIM shares are now allowed in an Individual Savings Account (ISAs) and SIPPs...etc.

Q. Small Caps don't seem to follow technical analysis rules?

A: Yes, you're right there - technical analysis works best on frequently traded liquid stocks (especially blue chips) or other instruments that are highly liquid. Most small caps are infrequently traded and thus prone to price gaps. The daily charts are thus likely to look quite jagged and intraday charts may have big blank areas where no stock has exchanged hands. Volatility without volume is like the flip of a coin. In an instant, the price could be up 5% or down 5%. What trend?

So as a general rule technical analysis is easier to implement on more liquid stocks although I would not dismiss it as impossible or useless on less liquid stocks (if there is a large seller in a small cap it could either be the case of a distressed seller or something fundamentally has changed).

Q. I've noted that spread betting firms will not offer guaranteed stop losses on certain companies like RPT. Why is that?

A: In my experience, guaranteed stop losses are usually only offered on liquid FTSE 100 stocks rather than small, volatile shares like RPT (as the risk is far larger for the latter). Beware that using spread betting on risky small caps stocks is really piling leverage on top of leverage (since most small caps are already leveraged plays) and illiquidity which can be very dangerous.

In addition, a guaranteed stop loss comes at an additional cost over and above a "normal" stop loss. Small illiquid stocks can be subject to strange market conditions that may see the market maker moving the bid and offer quite dramatically.

You could consider the guaranteed stop loss to be equivalent to buying a put option at a given price with an (indefinite?) expiry date, which is automatically exercised when "in the money".

Q. What is the cheapest way of holding a small cap (outside FTSE 350) share through a spreadbet for a period of at least six months but possibly up to a couple of years? At the moment I am looking for Jarvis Securities, Lookers and Waterline Group.

A: IG Index has Jarvis plc and Lookers plc...

With a market Cap of only 11m and tiny volume you won't find Waterline with any spreadbetter.

I currently use IG Markets to hold my small cap stuff but I pay dealing commission and LIBOR + 2.5% to hold. However, I do get market spreads. Of course I also have to pay CGT though ;-(

IG cover all stocks down to £20M (I use them). MF Global (formerly Man financial) do shares down to £10M, though I don't use them.

Q. A question apart; can any dual listed AIM share be held in an ISA?

A: Only if the other listing is a so-called 'recognized' exchange - which several quite popular exchanges are not ;o) Here's a pdf document (opens in new window) with a list of which dual-listed AIM shares do or don't qualify.

Q. I've asked some questions regarding small caps to some of the big guns. Here are their responses:

A: Do you offer trading of small cap UK equities?

Finspreads - Yes, we do as long as the company has a market capitalization of at least £50 million and is liquid enough for us to trade.

City Index - I am sorry to inform you that we do not trade in Small Cap Stocks. Any UK stocks that do not have a market capitalisation of £50 million or more are not available to trade in with our Spreadbetting product.

What would it cost to hold a long position in one of these for say 18 months? Please also suggest which of your products would enable me to do this most cost effectively? i.e. using rolling/futures bets.

Finspreads - You could hold a position in the longest term quarter contract which will get rolled over 3 times to total an 18 month trade. The only charges that are incurred is when the position is rolled over these 3 times, whereby you pay a reduced spread on the newly rolled position, which for FWY would be minimal.

What are your margin requirements on Small Cap stocks? If you could send me a list with all tradeable stocks that would be useful.

Finspreads - Unfortunately we cannot send you a list of each individual margin requirement as this would be a list of literally thousands. However, we can state that for FTSE 100, margins are usually between 5%-10%, FTSE 250 5%-50% and FTSE ex 350 20%-100%. For FWY, margin is 25%.

How do you hedge the underlying clients' position in the market?

Finspreads - If you buy a spread with us, we will go into the market and buy the stock, thereby hedging your position so that all we make is the spread.

 ...Continues here - What is the ISDX Market?

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