Here’s How To Profitably Liquidate A Large Position In An Illiquid Stock

• November 29, 2004
• Melanie Hollands

Profitably liquidating large
position in an illiquid stock can be tricky. The rapid increases in
trading activity typical of these stocks can be excellent catalysts to take
profits. However, if there’s not enough liquidity in the stock to sell a few
thousand shares without disturbing the price the following points start to
become relevant. Furthermore, the larger the portfolio then the higher the
liquidity threshold at which these points become relevant.

 

Identify the broker who has an ax in the name.
It’s useless to try to sell an illiquid stock in quantity without a
broker who can make the calls to potential buyers and find the other side of the
trade. For many illiquid names there are really only one or two shops that can
accomplish the trade at all.

 

It’s best to sell illiquid stocks as a contrarian.
As and when the position reaches its target price, take advantage of the moment
and sell. Don’t wait to see demand wane and take that as a signal of a topping
stock; it’s important to have sold by then. Because trading against the supply
and demand becomes more important, it’s impossible to try to play a momentum
game since the transaction costs of selling large blocks of illiquid stock
(discussed in greater detail below) can be prohibitive.

 

Sell
during a favorable market. 

Sell when the stock is making a dramatic move higher.
If positive news propels the stock, take profits when it’s climbing. One
strategy is to sell 50% of the position; this way, the initial investment is
covered and the remainder can be held with reduced or little risk. However,
assuming the company’s fundamentals are intact then consider not selling the
entire position. It’s not always possible to tell how high a stock will go,
particularly with a turnaround story in a bull market.

 

Sell when the volume picks up, usually five to ten
times average daily volume or higher. I like selling illiquid names when they’re
making new highs and generally get out while they’re still in play. But be
careful; because when in a position and the volume dries up it can be difficult
to get out and sometimes it’s outright brutal. Ideally, the trade should have an
event or catalyst to move the stock price and provide a selling
opportunity. I’ve found illiquid names work best on breakouts with volume and
hold them so long as they stay above the 10-day moving average.

 

Never sell the entire position in one trade.
Favorable market conditions can be excellent opportunities scale out of large
illiquid positions. Small companies are often susceptible to setbacks and delays
in execution of their business plans. This can lead to a drop off in market
interest and a decline in trading volume and stock price. If the fundamentals
get back on track this catalyst can propel the stock price and present a great
selling opportunity. If the stock continues to trade up, scale out of the
position at progressively higher levels if the company continues to perform
beyond expectations.

 

Trade smaller positions. Instead of liquidating
with 50,000-share positions, think 5,000 shares. This helps in terms of order
fill and minimizing the impact of the trade on the stock price. That said,
although trading more and smaller positions can deliver better sale prices it
also increases the liquidation costs. This makes the above two points all the
more important in order to optimize total profits on the position.

 

Be patient on executions. When liquidating the
position use limit orders, wait days to get filled, never go market, and
never chase a price down. Instead of having to sell in a hurry to exit the
position, scan where the stock has been trading for the prior week or two with
particular attention on the prior few days. Then choose an area near the top end
of its recent trading range. Sometimes this means missing out on selling at that
particular time, but if the fundamentals are intact there should be more
positive catalysts to present selling opportunities.

 

Never account for more than 25% of a microfloat’s
trading volume over four days. Allied to this, I try not to hold a small cap
name that’s more than 50 basis points (bps), or 5%, of the total asset base of
the portfolio. Although getting the position to this size is questionable since
I try to never be more than 25% of volume over four days with these little
stocks. Otherwise, I risk moving my own market. The logic is simple: if the
stock falls 20%, then I’m giving up 10 bps (1% of the total asset base) and that
I can handle. To be in a large small cap position in the first place, I would
need to be excited. But often there’s no way to shield the position from the
violent fluctuations that occur when some small, say 600 share, sell order –
usually the options exercise of some bitter fired employee – hits without a
buyer around and the stock drops 10%. Often the small cap investor just has to
shut their eyes and wait for the stock to rebound. That said, I realize that my
“50 bps” rule of thumb is a rule I do break, particularly if I believe strongly
in the fundamentals. The better metric to use is the percent of daily volume.

 

Always use limit orders to sell. Market makers are
in business to make money on trades and they’re ruthless. Since illiquid names
typically trade in low volumes, are higher beta, and tend to be volatile market
makers can fill a market order to the seller’s detriment. Choosing the best
price to bid for a stock can make a significant difference in terms of overall
returns. Over eager sellers often select the market price to make their play,
deciding they must sell the stock now. While this does guarantee a sale,
it rarely delivers the best value or longer-term return on large positions.

 

Place
an “all-or-nothing” order 

Never
place a market order when a stock gaps up or down at the open.
Again this gets down to the nature of market makers; when they have market
orders for a stock at the open, they often take a stock up or down and fill at
exaggerated prices. So to sell the stock at a particular time, it’s better to
place a limit order between the previous day’s close and the opening gap price.

 

Make
sure you’re right on the small cap company’s fundamentals.
There’s no room at the door for a sudden exit. It’s paramount to perform
vigilant due diligence on these smaller names. Playing with the thin names means
exposure to the chat board type traders. Chat boards are fertile ground for the
dissemination of information that is dodgy or outright incorrect, and often
designed to deliberately manipulate an illiquid stock’s price.

 

Costs

Some of the above tactics can help limit the downside but
can also increase total liquidation costs. Trading costs are one of the most
overlooked and yet subversive elements of profitable trading; particularly when
selling large blocks of illiquid names.

 

Total liquidation costs include four components:
commissions, price impact of trading, delay costs (when a trader decides to wait
to sell) and opportunity costs (as a result of not trading, or partially
completing, a transaction).

 

Low commissions can lead to a false security because they
are not the only component of liquidation costs. Every sale can impact the
market price of the stock and require a waiting period before the price rebounds
and moves back in favor. To trim a large position in an illiquid name requires
taking the trade while it’s there. Passing on the trade while its possible to
execute it means making a conscious bet that the underlying business will
improve between now and the next sell opportunity, which could possibly be
months away.

 

Other things that impact small cap stock liquidation
costs include trading frequency, timing of the trade during the day, and choice
of broker, all of which can result in lower-than-expected after-cost
performance. A cheap broker may cost more in the long run because of poor
execution. Some are far less likely to rape (or front run) on execution than a
large brokerage firm. I’d be more wary of a Citigroup or a Goldman than of CRTC
or IMPC. To the small boutiques, a small cap investor can be a significant
long-term customer and therefore can be treated like an annuity, not a trade. To
the bulge-bracket brokers, small cap investors can never be significant
investors to them, they know it, and they treat those investors that way.

 

Choose a broker who can and will feed the position out
slowly. It may be possible to negotiate to execute the entire transaction over
time for a flat “per share” fee. But be vigilant watching the tape and the
prints because some brokers (and I recommend staying away from them) may try to
mark-up the spread. This eats into small cap profits particularly if the
original cost basis is tight and the liquidation and other transaction costs are
high. Finally, if negotiating a fixed fee with the broker, make sure this
doesn’t preclude capturing upside if the market rises.

Melanie Hollands

For 14 years, Melanie Hollands
has covered the technology and telecommunications sectors, from positions held
in business strategy (McKinsey & Co., Bain & Co.), corporate finance (Salomon
Smith Barney) and fundamental equity research (Merrill Lynch). She follows
PC/server/storage hardware, enterprise and application software, wireless
hardware/software/middleware, data networking and telecom equipment, optics,
semiconductors, semi capital equipment, and various niche technologies (RFID,
WiMax, VOIP and others). Hollands is president of Koala Capital (located in
Aspen, Colo., and New York City), which focuses on trading/investing in
technology stocks. She is also a senior advisory board member for a start-up
financial services venture, the Semiconductor Futures Exchange Inc., and an
advisory board member for a start-up Linux-HPC venture, Tadpole Ventures, LLC.
She has been a guest lecturer and adjunct professor at Columbia Business School,
where she earned her MBA, and serves as an advisory member for various faculty
departments. She also holds a joint bachelor’s in Architecture and Structural
Engineering.