Small Cap Stocks Trading Strategy
Small cap stocks are unlike any other stocks you’ve traded. They’re closer to trading options than large cap stocks or ETFs.
Their wild swings in price can have you on the edge of your computer screen. Moves of 5% on any given day are not out of the question. And thinking you know the next move is akin to convincing yourself that you can predict the weather.
Inconsistency is the only consistency!
Small cap companies occupy the space between $100 million and $2 billion in market capitalization (share price times the number of shares outstanding). They share the following characteristics:
- Low Float
Small cap stocks don’t have a lot of shares in public hands that are available to trade on a day-to-day basis. So you can get wild swings in price, as there are not as many buyers and sellers at any given time. A low float can also be considered a low liquidity situation.
- Less Analyst Coverage
The average large cap-established company will have dozens of Wall Street firms covering it. That leads to many opinions from those who have researched the company. They cover companies for two reasons. The first is in hopes of garnering future investment banking business. The second is to try and develop a following through good track records. Not having coverage can lead to significant gaps in news flow from sources outside the company, and that can lead to small cap blackouts. Rumors can move prices much more than facts.
- Lack of News Coverage
Small caps don’t have a lot of money for big public relations or investor relations departments. That leads to a lack of news.
- Wild Trading
Not having much insight into a company can lead to wild trading in the shares, as investors tend to react and overreact to news that might be scarce or opinions that might be inaccurate from sources not affiliated with the company.
When there is legitimate news, the shares can move up or down by double-digit percentages in a single day. For small cap biotech stocks, this can be magnified even further on good or bad news about a promising drug or trial.
Small caps are not for everyone. They are very volatile, and as a result, their trading often scares investors out of a position thanks to wild moves, especially moves lower in price that can happen on no news or company-specific events.
When we recommend small caps in The War Room, we take two precautions. First, we recommend entering the trade using a half position. That means we like the shares at the current price and think they will move much higher.
We also know that small caps can be dormant for a period before they begin their ascent. Knowing this, we are happy to wait and recommend members enter with the second half at lower prices. In other words, we are very aware that the price will likely move lower, just as we are aware it may move higher.
We also establish a much wider stop loss – usually 50%. That seems extreme… and it is.
Normally, we recommend a 25% stop loss on larger cap stocks, as they have much more established trading patterns and are less subject to wild swings. When a swing occurs on the downside, there is usually news to justify that move down, and we don’t want to be in that situation for greater losses.
With small caps, a 10% or 20% move is not abnormal, and having a tight stop could knock you out prematurely.
Action Plan: Small caps have huge profit potential since many aren’t and have low liquidity. Any good news can magnify upside moves – and the opposite is just as true. That said, we are selective in what we buy in The War Room. We look for catalysts like insider buying, potential deals with larger companies, clinical trial results and more. But we do so knowing full well small caps don’t trade like normal companies. Therein lies the risk… and the rewards!