On the New York Stock Exchange alone, three to four billion shares are traded daily. This includes everything from penny stocks that trade for a few cents per share to Berkshire Hathaway Inc. which currently trades at over $170,000 per share. It also includes various security types outside of traditional stocks, such as preferred shares and exchange traded products. One key to implementing and executing a successful investment strategy is to understand how trades work.
One key concept to understand is that prices of securities are dynamic and not static. A static price would insinuate that an investor could buy or sell as much or as little as they wanted at a given price. Instead, prices of securities are dynamic and driven by supply and demand. As the demand for a security increases and more individuals want to buy it, the price of the security will increase. As the demand from buyers outweighs the supply of sellers, the price will have to rise to incentivize owners to sell.
This will satisfy the demand for the security and achieve a balance between buyers and sellers. These same dynamics of supply and demand apply if the supply to sell is greater than the demand to buy. In this case, the price will decrease until there is equilibrium between buyers and sellers.
Another important aspect to understand is liquidity of a particular security. However, before we can discuss liquidity we need to first understand what a spread is and how the bid and ask work.
A bid is the amount of shares someone is willing to buy of a security at a given price. Alternately, an offer is the amount of shares someone is willing to sell of a security at a given price. The difference between the highest price someone is willing to buy the security and the cheapest price someone is willing to sell the security is known as the spread. Based on the spread between the bid and ask, investors can get an idea of how liquid the security is.
The liquidity of a security is the ability of security to be bought and sold in the market without affecting the security’s price. A narrow spread of one penny indicates there are many buyers and sellers in the market and that one could purchase a rather large position at once without moving the price drastically. An example of security like this is Microsoft Corporation.
In comparison, a wide spread indicates that there are not as many buyers and sellers in the market. As a consequence, if an investor wished to purchase a large position in a security over a relatively short period of time, they would drastically move the price of the security. An example of an illiquid security would be a small cap stock. One reason spreads are much wider for illiquid securities is that those providing the bids and asks are requiring potential investors to pay a little more to purchase the security or receive a little less to sell the security in exchange for the transfer of liquidity risk.
Successful investors will analyze spreads, liquidity and other indicators as a part of their trading strategy. Doing so will help them get the best price available and take advantage of opportunities in spreads and liquidity. While this may sometimes be difficult for individual investors to do, they also have the ability to do so by utilizing the services of a well-seasoned, active investment manager.
Such managers will monitor current and potential holdings throughout the day to recognize any buying or selling opportunities that appear in the market. A successful manager and trading strategy will not only help with capturing profits from securities’ mispricing, but they will also help establish the appropriate asset allocation to help investors reach their ultimate goals.
Byron S. Sass is a fixed income analyst/account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.