Stock float and Its Impact on Stock Price
Stock float is one of the most important metric that can influence the price of the stock.
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While there are a number of metrics available to evaluate stocks, the float is an important factor when picking stocks. Obviously, you cannot expect to randomly pick a stock to trade. Understanding the underlying factors behind the stock price is important.
This is where the stock float plays an important role.
Of the number of shares that are tradable, the shares are either freely tradeable or insider owned shares. Inside shares are not often looked up as they are illiquid.
For the most part, inside shares are owned by the employees of the company they work for. The insider owned shares are not easily tradeable as they come with restrictions. The markets at large don’t bother much about the insider owned shares.
Free floating shares are owned and traded by the general investors. In many cases, institutions also own the shares. These institution owned stocks are also held for a long time. Examples of institutions include pension funds, hedge funds that are in for the long haul.
Most of the stocks held by institutions do not actively trade the stock as an average investor or a day trader might trade.
What is a stock float?
There are many metrics that traders could follow when it comes to stocks. However, the float of the stock or the stock float is also important.
Stock float is important because you can make an educated guess on the volatility and liquidity of the stock.
The float of the stock measures the total amount of shares that can freely change hands. As you can see the float in a way depicts the liquidity of the markets. The more number of shares there are to change hands, the greater the liquidity.
Although it is not recommended to trade stocks with lower float, the price is reactive and the stock more volatile during an early period of a company’s life. For such low float stocks, a fundamental driven rally creates demand. This in turn makes the price more expensive.
Stocks with high float tend to be more predictable. This is because due to the large number of float, the liquidity can absorb any big moves. Therefore, while it is common to see 30% or 40% move in a low float stock, this is not very often found with high float stocks.
A high float stock, as the name suggests is one that has a high number of freely tradeable stocks. Larger companies such as AAPL or FB are examples of stocks with high float.
It is usually beneficial and a safe bet to trade stocks that have a high float. Usually, a company’s good will is measured based on the float. It reflects the public interest in the stock.
Example of a Floating Stock
To understand floating stock, let’s illustrate this with an example.
A company ABC Inc. has 50,000 shares outstanding.
Of the shares outstanding, 5000 are held by its employees, 20,000 shares are held by institutions and he remaining are held by regular investors.
From this, the stock float is 45,000. This is the sum of the total outstanding shares minus the shares held by insiders.
What is the difference between market cap vs. free-float market cap
Market capitalization or market cap for short is closely linked to free float of the stock. When you research on stocks you can see that companies are categorized based on their market capitalization. Question is whether you should pay attention to this.
Market cap is a measure of a company’s size.
Market cap is measured as the total value of a company’s outstanding shares of stocks. These outstanding shares include publicly traded shares as well as restricted shares that are held by insiders.
In simple words, market cap tells you the size of the company’s valuation.
To calculate market capitalization you simply take the number of a company’s shares that are outstanding. Multiply the shares outstanding by the current stock price in order to get the market cap of the stock.
How to calculate market capitalization
Let’s illustrate this with a simple example.
Say a company ABC Inc. has a total of 5 million shares outstanding. If this company is trading at a stock price of $10, you can get the market cap by multiplying the shares outstanding with the stock price.
In the example above, we get $50 million as the market capitalization of the company.
Within market capitalization, there are certain classifications. The different categories can vary depending on who you ask. However, market capitalization is broadly classified into the following:
- Large-cap: Large cap stocks have a market value of $10 billion or more;
- Mid-cap: Mid cap stocks have a market value between $2 billion and $10 billion;
- Small-cap: Small cap stocks have a market value between $250 million and $2 billion;
- Micro-cap: The smaller of all, the micro cap stocks have a market value of less than $250 million.
Now that we understand what market capitalization is we can see the difference. Market cap is based on the total value of the company’s shares. But a float is the number of the outstanding shares that are available for general trading by the public.
To rephrase this, market cap measures the total valuation of the company. A float measures the total number of free floating shares that are available minus the restricted stocks.
The free float calculation method
There is also another measure called the free float method of calculation. In the free float calculation method, the market cap excludes shares that are locked in. The shares that are locked in are inside shares that are not available for the general public.
Generally, the free float method of calculating the market cap is widely used. Major indexes such as the Dow Jones Industrial Average and the S&P500 make use of the free float method.
Free float and market cap are important metrics for investors. When combined together, these two values show the total available shares for the public to trade.
Can the stock price be manipulated with float?
One of the questions that come to mind is whether one can manipulate the price of a stock based on the float. A reduction in the float can almost immediate raise the price of stock. This might seem contrary to the notion that higher the float, bigger the price.
This is not the case however. For example, when risk averse investors are on the short side of the stock, reducing the float can squeeze these investors out of the market.
This research paper of Float manipulation and stock prices gives insight into how firms can expand or shrink the float. The research paper takes a look at Japanese stock listings and looks at the price impact when firms reduce their float between 0.1% up to 100% for periods of one to three months.
The research paper shows that consistent with the theory, the price of a stock tends to rise when the float is reduced and conversely, the price of the stock falls when the float is increased.
The returns of the stock are also said to be cross-sectionally related to the reduction in the float.
There is evidence that firms tends to issue equity or redeem their convertible debts when the float is low. The paper follows through showing that firms have strong incentives for manipulating the stock price via its float.
What is a low float stock?
A low float stock as the name suggests indicates that the number of shares outstanding are low. For such stocks, the daily and average volume tends to be low. The low volumes of such stocks lead to volatility and as a result, wide bid and ask prices.
There is a myth that low float stocks are mostly stocks on the pink sheet or OTCBB market listings.
However, this is not the case. In some cases you can find some micro-cap stocks with listings on the main exchanges such as the NASDAQ or the NYSE. A stock can also be low float if for some reason the float reduces relative to its usual average.
While there is no actual definition, a stock is a low float stock which has fewer than 15 million in tradable shares. It is once again important to understand that shares outstanding measures all the shares available. This is inclusive of both tradeable and non-tradeable shares.
Therefore, shares outstanding are typically higher when you compare to the float. Stocks that have low market cap and low float are ideal for volatility and price manipulation. They are also not the ideal stocks to trade as they attract higher bid and ask prices.
Can company increase or decrease its float?
The answer to this is yes. Companies can raise or decrease their float in two ways.
A company can raise the float by issuing new shares and it can reduce the float by announcing buy back of the shares. Other examples include a company announcing a stock split which could impact the float.
Insider activity is also one of the factors influencing the float. For example, insiders who usually own options can choose to exercise their option. This can also influence the float. However, for this to occur there needs to be a significant amount of option exercises.
A company can also increase its float by deciding to sell some of the inside shares. This is done for legitimate reasons such as raising cash, but there could also be ulterior motives. Typically, you can see the float changing when there are some big changes. The trigger for the changes to the float can be due to the fundamental drivers such as news events or company reports and rumors.
Low float stocks – pros and cons
As you might expect by now, there are pros and cons when it comes to trading stocks with a low float.
Let’s talk about the upside first!
Because low float stocks are volatile, there is a tremendous upside to the stock. Traders who can take a calculated risk on low float stocks could end up being with big returns in reward.
Manipulation is however easy when it comes to low float stocks with price action susceptible to large unexpected orders. This is something that investors need to bear in mind.
Despite the inherent risks, traders can find an occasional good trade with tremendous upside potential in low float stocks. One of the important things is to look for liquidity.
Low float stocks can be very risky to hold because they can have violent moves in either direction. With so few shares available to trade, the impact on supply and demand can be significant.
Stocks with low floats also tend to be volatile around fundamental news releases. These include any type of news that is related to the industry or the sector in particular. Liquidity also increases around such events which can give good opportunity for investors to exit the stock after making a good trade.
The disadvantage of trading low float stocks on the other hand brings a lot of risk as well. For one, liquidity and the spreads can be the biggest deterrent. In a way, trading the low float stocks can be similar to trading penny stocks or micro-cap stocks.
Remember the risks of trading with low float stocks
While it might seem tempting to trade low float stocks due to the potential they have, one needs to be cautious. The potential for generating big results is often one of the factors why some traders prefer to trade low float stocks.
Likewise, the risks of being wrong and being unable to offload your stakes in such stocks can be disastrous as well. Sometimes traders end up trading low float stocks simply because they didn’t pay attention to the stock itself.
As a thumb rule, investors and especially day traders need to be careful when it comes to picking stocks. Paying attention to the market cap and the float of the stock takes just a few minutes of your time but it would save you from making a big mistake.