Original question: In your Defense article, “My rules to minimize losses in the stock market“, in the Layer 6 section, you say, “Be careful trading in stocks with a high outstanding/float share ratio”. Approximately how high of a ratio would you consider a cutoff limit or at least a red flag?
Let me first elaborate a little further.
The share float or public float in comparison to the total outstanding shares issued by a publicly traded company is a ratio which tells something about the ‘real size’ of a stock.
- When the float is much smaller it increases the potential volatility
- When the float is small it introduces dilution risk just like secondary offerings.
You could argue that the volatility doesn’t change when the float remains constant, which is true! However, a trader who buys based on the market cap (total outstanding shares multiplied by share price) could be hit right between the eyes. Imagine you buy a 500M cap stock and place a normal stop based on your experience with that kind of cap. Your stop could be triggered easily.
How can I improve my edge with the outstanding / float share ratio?
Well, It can be used to calculate, what I call, the effective market cap. The absolute value of the ratio isn’t as important as the resulting effective market cap. When a ratio pushes the effective market cap below my 220M USD market cap limit, I have to pass on the stock as it failed my Basic Fundamental Quality Check.
But it is also not a good omen when the share float is much much smaller than the total share count even when the effective market cap is above the threshold as the dilution risk is still there. Imagine that -for whatever reason there is- all the privately held or restricted shares are unloaded into the open market. This would create a severe short term supply/demand imbalance depending on the actual numbers. I don’t want to be hit by that ever. It is a hidden risk just like ‘drug-trials gone bad’ in the biotech sector.
If you can be sure that the private shares will not hit the market anytime soon then a ratio of 0.5 (The open market float is 50% of all shares) would still be ok. One reason for that would be the IPO lock-up period. Anything below 0.5 raises a red flag and demands more research. I violated this soft rule in the past as well, especially in IPOs.
It helps when you learned to identify illiquid trading behaviour from the chart on the spot. You can also check the weekly and monthly volatility directly in the Finviz Screener or indirectly via our stock quality checker. Monthly volatility should be reasonable and comparable with other quality growth stocks in the same EFFECTIVE market cap range.