From Dan Caplinger: Everyone’s talking about marijuana stocks after their impressive run so far in 2019. As more jurisdictions look at legalizing cannabis use, the potential market for pot products gets bigger — and the companies that have positioned themselves to take advantage of a growing market look more attractive.
Yet as awareness of marijuana stocks grows, so, too, do some of the dangers involved in investing in them. In particular, there’s one aspect of buying and selling shares of cannabis companies with which even experienced investors aren’t entirely familiar. If you make this key mistake, it can eat into your profits and even turn gains into losses.
What great investors need to succeed
Investors count on liquid markets to allow for smooth trading. When you buy shares of a stock, you naturally expect there to be someone on the other side of the trade looking to sell. When it comes time to cash in, you similarly expect there to be someone else willing to buy those same shares back from you.
With many high-profile stocks, there’s so much liquidity that ordinary investors almost never have to worry about not being able to find someone on the other side of a trade. The most popular stocks see tens of millions of shares change hands each day, and that lets even large purchases and sales go through under the radar in terms of causing price disruptions.
Why little pot stocks carry big risks
In the cannabis investing arena, unfortunately, liquidity isn’t always as readily available. Because many up-and-coming cannabis stocks are Canadian companies that list primarily on Canadian stock exchanges, U.S. investors have limited choices to purchase shares. Many brokerage companies allow U.S. investors to trade directly on Canadian exchanges, but there are often additional fees involved. Alternatively, U.S. listings on over-the-counter or pink-sheet markets are typically available for many smaller marijuana stocks and allow investors to buy and sell shares without going to a foreign exchange.
However, over-the-counter and pink-sheet listed stocks tend to have much less volume. As an example, take premium pot producer Supreme Cannabis (NASDAQOTH:SPRWF). The average volume on this $1.50-per-share stock is about 450,000 shares. When you look at minute-by-minute trading activity, trades of just a few hundred shares are common, and many trades result in the stock price moving by a full penny.
That might not sound like a big deal, but it highlights one hidden cost of trading: the bid-ask spread. With all stocks, you’ll pay slightly more to purchase shares using a market order than you’d get if you wanted to sell shares at exactly the same time. With a $100 stock in a liquid market, a $0.01 difference won’t make a big dent in your profits. But with a $1.50 stock in an illiquid market, the same $0.01 spread is two-thirds of a percent. Especially for frequent traders of these illiquid securities, spreads can kill your returns even if the overall trend for the stock price is up.
How to handle illiquidity risk
One reason why the top marijuana stocks have sought to list their shares on major U.S. exchanges is to bulk up their trading volume. Before Canopy Growth (NYSE:CGC) uplisted to the New York Stock Exchange, its typical daily trading volume was anywhere from 275,000 to roughly 2 million shares. Since then, the stock has had long streaks of days trading 10 million shares or more. Similarly, Aphria (NYSE:APHA) has seen surges in volume since its November uplisting, going from peak trading days of around 5 million shares during the cannabis craze last October to four straight days of 25 million share trading volume in December. In general, bid-ask spreads on the NYSE and Nasdaq are narrower than you’ll find in more obscure markets like the pink sheets.
If you really want to trade a stock that’s not on a major exchange, though, there’s a way to manage illiquidity risk: use limit orders. A market order leaves you at the mercy of other traders, and if there isn’t sufficient interest to take the other side of your trade, you could end up moving the price in a way that’s costly. But with a limit order, you essentially set the market, waiting for others to come to you with their trades. The downside of limit orders is that there’s no guarantee that anyone will accept the price you set, and the stock price can move away from you without your having executed your trade.
In addition, frequent trading is a no-no with illiquid stocks. If you like one, be ready to commit to it, making a single trade and holding onto your position. The more you buy and sell, the bigger an impact the bid-ask spread will have.
Be a smarter marijuana investor
Many marijuana investors have never had to deal with illiquid markets before, and the situation introduces new challenges to overcome. By being aware of the risk, though, you can take steps to reduce it and improve the odds of your success as an investor in the cannabis industry.
The ETFMG Alternative Harvest ETF (MJ) rose $0.03 (+0.08%) in after-hours trading Tuesday. Year-to-date, MJ has gained 12.44%, versus a 5.15% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of The Motley Fool.
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