PRICE AND TIME

are two variables of investing, but liquidity the ease with which an asset can be bought or sold without affecting the price is an equally important component to successful trading.

Liquidity is generally thought to be a net positive. We often hear about investment managers seeking liquid stocks. But as we've written about many times over the years, in strong, high-probability opportunities, illiquidity can be a plus. As speculators, we assume that risk by buying XYZ. The risk is where the opportunity is. And while risk exists, we try to mitigate it by buying it at the right time and in the right way. That's technique, or what we refer to here as Tradecraft.

For most small investors, a stock's liquidity is something they never even consider. We assume that a 100-share market order can be easily filled, and that if you wanted 100 more you'd probably be able to get them at the exact same price. Indeed, the average Joe Six-Pack is a small fish, which in trading is actually a big advantage. The 100-share crowd can buy or sell anything from Cimatron Ltd. (market cap: $10.6 million) to Exxon Mobil (market cap: $431 billion) without budging the price. An individual investor with $50,000 to $100,000 to invest can usually get a 5% position in most any stock, usually in one or two trades.

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The difficulties start as you grow to become a larger investor. In order to establish that same 5% position, the trader must obviously buy more shares. This is why big stock mutual funds generally buy big stocks: They're just too large to own anything thing smaller than multi-billion dollar firms.

It's why Fidelity Contrafund, with more than $70 billion in assets, has to buy stocks with an average market cap of $33 billion and a generous portion of the top holdings are names like Hewlett-Packard, Bank of America and Exxon Mobil all stalwarts of the S&P 500.

In order to take a 1% position in a stock means the manager must buy roughly $700 million worth of it. That's more than the entire market capitalization of many promising smaller names.

Of course, when a stock's market capitalization is small, so too usually is its relative liquidity. And while I generally prefer trading using market orders, they'll wreck you in a stock that's too small for your account. For example, although my fund currently has no position in the stock, I can claim personal responsibility for a number of visible historic moves in Brazil Fast Food Corp. because of foolish orders that pushed the stock, at least temporarily.

Liquidity demands liquidity now. So when you go to buy 10,000 shares of XYZ at the market, you are saying I want those shares this moment, and I'm willing to pay whatever the immediate market will offer. If the stock only trades a few thousand shares a day, huge blocks aren't likely to be readily available. So you buy the first 100 at the offer, a few hundred more of scattered limit sell orders on the first few percent higher, but get the majority of the position from the professional market maker a good 10% to 15% higher from where you first placed the trade.

Moreover, liquidity, or lack thereof, often tends to feed on itself. Case in point is when one trader's liquidation can trigger a cascade of sales. So you try and sell 10,000 of small-cap XYZ at $15 in a thin market with only 100 shares bid. You might push the stock down to $14.75 on that order alone. Then every other weak hand, some even bigger than you, start dumping their 1,000-share blocks at the market. All of a sudden, the stock is sharply down on no news. It was simply one player who just wanted out.

For individuals with large, multi-million-dollar accounts, I think the trick starts in realizing, as these large funds do, that some stocks are simply too small for your portfolio. Even Rick's Cabaret International, a well-known micro cap with institutional following and numerous mentions in The Wall Street Journal, has a $46 million market cap and only trades around 100,000 shares a day. At $8 a share, that's about $800,000, peanuts to a large account who might need $1.5 million just to get cursory exposure.

Small stocks also demand limit orders, but not the way most people tend to use them. If a stock is $15.50 bid for 200, and 200 offered at $15.60, most people will put in a limit order for their shares at $15.40 or $15.30, hoping to accumulate a position buying dips. I'd prefer to improve the bid, say by bidding for 200 shares at $15.55 or buying the offer. If you buy 200 shares at $15.60 and suddenly there's another 200 offered at the same price, chances are there's even more likely to come out of the woodwork.

I'd also avoid "showing your hand" by bidding for your entire position. If you put in a limit order for 20,000 shares in a stock that only trades 5,000 a day, you've just tipped off the entire world to the fact there's a big buyer hungry for XYZ. That's when sellers start pulling and raising their offers, making it more expensive for you to get in.

Finally, when it comes to adjusting a portfolio, I try and not trade in the first hour or so of the day unless a stock specifically hits my target buy price. Most amateurs come in anxious to trade and looking for action, meaning that there's a lot of "herd" money bet within the first 15 minutes of the opening bell. After the first hour I believe one can get a better picture of how a deep XYZ's liquidity actually is.

That's the frustrating thing about liquidity. When you have it you don't need it. And when you need it you can never get enough. The disciplined trader looks to provide it when nobody else will, and take advantage of it when there's plenty to go around.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. Hoenig had no positions in any of the securities mentioned at the time of writing, although positions can change at any time.