Lesson 4 of 25 · 7 min

Why a single equity sits in the middle, and a thin one near the bottom

Two stocks at the same price can sit thirty points apart on a schedule, and the reason is the order book.

Once you leave cash and government paper, two variables set the row: how far the price can move, and how long it takes to sell the size you hold. The second is the one borrowers never think about and lenders think about constantly.

Price movement is estimated from volatility. A name moving 24 percent a year moves about 1.51 percent on a typical day, since 24 divided by the square root of 252 trading days gives 1.51. A name moving 62 percent a year moves 3.91 percent a day on the same arithmetic. That is already a wide gap, and it widens with the square root of the number of days the sale takes.

Time to sell comes from traded volume. A lender assumes it can be some fraction of a day's volume without pushing the price around — 15 or 20 percent is a common assumption — and divides the position by that. A position that is a rounding error in a deep name takes hours. The same dollar amount in a name trading a few hundred thousand dollars a day takes the better part of a week, during which the daily price move applies four or five times over.

Those two inputs set the ordering and the spacing of the middle and lower rows. They do not set the level: an advance rate is not simply one hundred minus a stressed price move, for reasons the next lesson but one takes up. What they explain is why a well-run small company can sit thirty-five points below a mediocre large one, and why nothing in that gap is a verdict on the business.

Key terms

Participation rate: The share of a day's traded volume a lender assumes it can sell without moving the price. Turns a dollar position into a number of days.
Days to liquidate: Position size divided by the volume the lender assumes it can trade each day. The multiplier on every other risk in the position.
Annualised volatility: The typical yearly range of a price, quoted as a percentage. Divide by about 15.87 to get a daily figure from trading days.

Worked example

Two positions of the same size

$340,000 in a widely held company and $340,000 in a small one. Illustrative volumes and volatilities.

Large name, average daily traded value: $85,000,000
Small name, average daily traded value: $420,000
Days to exit at 20% participation, large name: 0.02 days
Days to exit at 20% participation, small name: 4.05 days
Daily price move, 24% and 62% annualised: 1.51% and 3.91%
Where the schedule places them: 60% and 20%

One position is gone before lunch. The other is exposed to four days of a price that moves two and a half times as much each day.

Check yourself

A pledged position is worth $290,000 in a company whose shares trade about $640,000 a day. The lender assumes it can be 15 percent of daily volume. How long does it assume the exit takes, and how does that compare with the same $290,000 in a name trading $40,000,000 a day?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.