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Got it? Good. Happy Cyber Monday. Now go get the deal!
OK, now let’s talk small-cap stocks. You need to know about this …
In terms of life and career, most people want to think big. But in the stock market, sometimes it pays off to think small.
When you purchase stocks from large, established companies, you may make profits over time. But it can take months or even years.
If you want to grow your account faster, you need to consider trading different types of stocks with greater volatility, since they can potentially offer a greater (and quicker) return. Small-cap stocks are one such option.
Small-cap stocks offer you the opportunity to invest in growth companies and potentially earn profits. In this post, I’ll introduce you to small-cap stocks, including what they are, how to find them, and how you can benefit by trading them.
Table of Contents
- 1 What Are Small-Cap Stocks?
- 2 How to Research Small-Cap Stocks in 5 Steps
- 3 Key Tips on How to Invest in small-cap Stocks
- 4 The Bottom Line
What Are Small-Cap Stocks?
No, we’re not talking about hats for small heads here. The cap in question here is the market cap, or market capitalization.
Market cap is an important metric for traders. It refers to the total market value in dollars of a company’s shares outstanding.
Market cap is used to determine the size of a company, versus just looking at sales or total assets.
Figuring out a market cap is extremely easy, even if you failed high school math. All you need to do is multiply the company’s total number of shares by the current share price.
So, say a company has 1 million shares, which are being sold at $5 each. You’re looking at a market cap of $5 million.
Once you figure out a company’s market cap, it can help give direction to your technical and fundamental analysis.
Determining the market cap can be a helpful method of filtering stocks of interest. It can also help you choose stocks from companies of various sizes, which can add diversity to your portfolio.
Now that you understand market cap as a concept, what is a small-cap stock?
Depending on the market cap calculation, companies will fall into various size categories, ranging from micro or nano-cap stocks (this category would include penny stocks) to small, mid-cap, and big/large and even mega-cap companies (like Amazon).
In terms of size, a small-cap company would be considered one that falls between $300 million and $2 billion with the market cap formula.
If that sounds pretty large, that’s because it is. However, consider the fact that a mega-cap company might have a market cap at $200 billion or higher. Compared to a big and established company, the small-cap company is small potatoes.
Small-Cap Stocks vs Large Cap Stocks
What does the market cap size actually mean, though?
Where a small-cap company would fall between $300 million and $2 billion with the market cap formula, a large-cap company would be considered between $10 billion and $200 billion.
That’s a pretty big jump in size. But that’s not the only difference. Here are some of the important differences between small-cap stocks versus large-cap stocks:
Company stability: Large-cap companies are not going to be up and comers. They’re established. Either they’ve been around for a long time, or they’re part of major industries.
Large-cap companies are generally recognizable to most people. Walmart, Disney, and General Electric would all be considered large-cap companies.
Considered stable and secure, the stocks offered by these companies tend to deliver long-term and reliable but slow returns. Investors can enjoy returns and dividends.
Small-cap companies are typically far less established than large-cap companies. This might be because they are a newer company, or they might be companies within up-and-coming industries.
Rate of return: As opposed to large-cap companies, small-cap companies can potentially provide a quicker rate of return. However, this can come with a higher level of risk.
Why so? Because they’re still growing. For example, it’s possible that a small-cap company went public fairly quickly, hoping to raise money. The issue is that this doesn’t give them a long log of financial history that you as a trader can research and evaluate.
Without much data, it can be harder to determine trends and patterns within the stock’s movement. This can throw a wrench in your stock research.
Seasonality: Depending on the time of year, small-cap and large-cap stocks may perform differently.
While small-cap stocks generally have a higher growth rate, they may not perform stronger than large-cap stocks all year round.
Small-cap strength can be stronger early in the year, possibly owing to what is called the January Effect.
The January effect is a phenomenon where buying is at all-time highs after the holidays. This follows a massive sell-off in December when lots of traders are selling off loser assets so that they can write them off come tax time.
Optimism is high in the new year, and many traders are willing to get in and try new things and invest in newer companies.
However, small-cap stocks can weaken as the year progresses. In the later quarters, it’s the stalwart large-cap stocks that tend to be strong. They’re less likely to be sold off during the December sell-off streak because they don’t tend to lose value.
Benefits of Trading Small-cap Stocks
These are some of the specific benefits of trading small-cap stocks:
- Take advantage of global trends. When investing in small-cap stocks, you can actually benefit from the same trends that might be affecting large-cap stocks.
According to Barrons, “In general, the two indexes tend to move in the same direction, despite some performance gaps. Since 1994, in 78% of the months when the S&P 500 lost ground, the S&P SmallCap 600 was down too.”
As the article goes on to share, in only 24 out of 297 months since 1994 has the SmallCap 600 lost while the S&P 500 gained.
This means that in general, you can look at sectors that are trending positively in the large-cap world and apply them to the small-cap world to find emerging opportunities.
- An opportunity for individual traders. Large-cap stocks are better known, but small-caps can give you the coveted edge as a trader.
Many big investors don’t waste time with small-cap stocks. These are the same people who turn up their noses at penny stocks, dismissing them as too volatile and risky.
This is true. The volatility is higher, and so is the risk. However, this is what allows investing in lower-priced or small-cap stocks to be so potentially rewarding.
The fact that fewer large investors are interested in small-cap stocks creates opportunities for people like you and me. There’s less competition, and if you’re willing to take a few extra steps and do thorough stock research, you can stand to benefit bigtime.
- Room for growth. The smaller the cap, the more room there is to grow.
Small-cap stocks are generally offered by less known companies. However, as the company grows, its revenues and earnings can increase over time. After a while, the public will become more aware of these companies, and the demand for the stock will grow.
If you can be ahead of the curve, you can benefit from this growth as a trader.
- Less analyst coverage. Say a big business like Amazon has a new product launch. It might move the stock a little, but probably not massively. Why is this? Because a million analysts have covered it, so you’re not getting in on some undiscovered opportunity.
A product launch for a small-cap company can have a much bigger impact on the stock price. But since smaller companies don’t get as much analyst coverage, it’s up to you to discover these opportunities.
The good thing here is that since many traders aren’t willing to put in this extra work, you can truly get in on the ground floor in this way. If you’re savvy about following the news and see such an opportunity, you’ll know it’s time to pounce.
- Small-cap companies are better poised for greater growth. Big companies are like a huge ship: harder and slower to steer.
Smaller companies, on the other hand, are much more nimble and can develop far faster. This can actually make them very appetizing as acquisition prospects for a larger company.
Rather than establishing a new branch or product division, it’s often easier and quicker to simply buy a smaller company.
This means that if you saw an opportunity in a small-cap company, and then it’s acquired by a large-cap company, you could potentially enjoy the financial rewards that come with that big news catalyst.
How to Research Small-Cap Stocks in 5 Steps
Ready to jump on the small-cap bandwagon? Here’s how to pick small-cap stocks:
#1 Technical Analysis
Technical analysis is what differentiates smart stock picks from random stock gambling.
By carefully evaluating what a stock has done in the past, you can get a good idea of what might happen in the future. No, you can never know exactly, but often enough, it follows a similar trajectory.
As my Trading Challenge students know, I consider myself a glorified history teacher. That’s because, in my eyes, trades live or die based on charts.
By looking at a stock’s chart over periods of time and based on various indicators, I find patterns that emerge over and over — and once I’ve identified them, I can predict them and use them as cues for where to enter and exit trades.
That’s not to say that this is how it works out every time. I’m not right all of the time, and you won’t be either. Sorry, but there are just too many factors at work. Single spikes can occur based on news or a big event.
However, frequently enough, stocks follow predictable patterns, and by observing and pinpointing them, you can take advantage of this phenomenon.
A great trading platform is key here. You’ll need to evaluate a stock’s specific price movements over time with technical analysis tools like the simple moving average, moving average convergence/divergence, relative strength index, and the parabolic SAR.
With small-cap stocks, it’s particularly important to get technical, because what data is available can be extremely helpful in allowing you to create an intelligent trading plan.
#2 Fundamental Analysis
As an avid follower of stock charts and data, it’s probably pretty obvious that I’m mostly focused on chart-based analysis. However, there is another type of analysis that’s also very important for every trader to include in their research: fundamental analysis.
Fundamental analysis involves poring over the company’s performance and researching who they are and where they are going. You’re looking for debt, how they handle their finances, potential big catalysts that could affect the price of the stock.
Fundamental analysis is important when researching small-cap companies because the fact is you might not have as much technical data to pore over. Fundamental data can help you determine whether or not it’s a good pick.
Yes, you will need to know some finance basics to get the most from your fundamental analysis. Check out this post on earnings reports to help you get a better idea of the specifics necessary for making the most of your fundamental analysis.
Where technical analysis is all about numbers, fundamental analysis offers a little bit more backstory about the company. In this way, both fundamental and technical analysis work hand in hand.
Together, you get a series of checks and balances. Technical research can support or refute fundamental analysis. Fundamental analysis can help make sense of the technicals.
#3 Use a Small-Cap Stock Screener
If you want to seek out the top small-cap stocks, you’ll need to sift through the many options that are available.
A stock screener can be immensely helpful in this regard. StocksToTrade is my favorite stock trading and research platform, which can be used to filter by market cap to narrow down the choices. In fact, I helped design it.
By cross-referencing the short list with other fundamental and technical indicators, you can begin to narrow down a list of the top dividend stocks to consider.
#4 Follow Stock Indicators
When you’ve determined a few small-cap stocks that you’re considering, let stock indicators be part of your continuing research. These are the things that can be the tiebreakers that help you choose one stock versus another.
High Volume and News Catalysts
Look for high volume and news catalysts when seeking out opportunities with small-cap stocks.
Volume is super important. You want enough shares being traded on a daily basis so that you’ll find it easy to get in and out of a position. You don’t want to be stuck with shares that don’t move!
High volume plus a great news catalyst is a winning combo. If there is an event such as an earnings report, an exciting new hire, or something else that could affect the stock, and it has good volume, it may be a good time to consider making a trade.
#5 Look for Clear and Easy Patterns
Why make things hard on yourself? Don’t make monitoring stock charts more complicated than it needs to be! Focus on the clean, easily identifiable patterns.
If you’re reviewing charts for low-cap stocks and can see no discernable pattern, move on. Don’t try to see things that aren’t there. That’s magical thinking and most likely it will cause you to lose money.
By trying to make a trade happen by force of sheer will, you could be missing out on actually viable and good idea trades.
Patterns are just that: reliable and repeating. By finding good, clean patterns, you’ll be revealing the best possibilities for stocks to trade.
Key Tips on How to Invest in small-cap Stocks
Ready to be a big fish in a small (cap) pond? Here are some of my key tips for how to invest in small-cap stocks:
Create Your Own small-cap Stock Watchlist
A watchlist is a trader’s secret weapon and a way to find your edge.
Tim Sykes Watchlist
I’m a huge fan of watchlists and send them out to the students in myregularly. However, I never say that you should simply follow the same stocks. It’s a starting point. Ultimately, I want you to be able to make watchlists yourself.
(If you want to check out my FREE watchlist every Sunday, here it is.)
Your watchlist is a small, manageable list of stocks that you’re considering. You want to keep it fairly small — after all, it’s easier to monitor five stocks than 20 or 100, for instance, especially if you’re a new trader and still learning how things work.
You will keep an eye on the stocks on this list to see if they meet your criteria. If and when they do, you can move forward with the trade.
To keep tracks of the stocks on your watchlist, you’ll be looking at indicators and looking for chart patterns volume, breakouts or breakdowns, or any change in the moving average.
Keep a spreadsheet for your watchlist so that you can track the stocks in question. Review them frequently so that you don’t miss any important moves. This way, when an opportunity presents itself, you’ll be ready.
If you’re curious about more tips for making watchlists, this video featuring my star student Tim Grittani is super helpful.
Invest in Small-cap Stocks That Offer Growth and Value
The reason why you’re seeking out small-cap stocks is that they can grow your account faster than large-cap stocks, which are steady but tend to be slower moving.
Small-cap stocks are more volatile, and therefore provide a greater potential for profits. However, you’re not seeking them out because you crave volatility. You want to embrace their volatility now because of the potential for what they can offer later.
Be sure to opt for small-caps that offer growth and value, because it’s the companies that are poised to grow will offer the most opportunities over time.
Never Chase Your Losses
There’s a strange thing that happens to traders who are in losing trades. Often, instead of recognizing that they’re in a losing trade and doing the right thing and cutting their losses, they start chasing.
They start telling themselves that things will turn around. This self-delusion causes them to stay in trades way too long, and they might even pour more money into a loser!
This is such a mistake! Sometimes, the hard thing is also the right thing, so it’s important to be quick in cutting your losses.
Cutting losses without emotion and quickly is vital if you want to be a trader long term. If you can’t do this, your losses will quickly mount and you’ll blow up your account.
Do not chase losses. Before you even get into the trade, make it part of your plan to determine at what point you will cut losses if things start going not your way.
And then — actually stick to the plan. Don’t get greedy, and don’t hope that things will turn around.
Don’t Trust Promoters
Marketing can convince you that you need something that you don’t.
Stock promoters are straight-up marketers, period. They aren’t trying to help you with the stocks they are promoting — they are trying to help themselves. Do NOT take them at their word.
I’m not saying that stock promoters are evil people. But they’re self-serving, and this makes them biased. So while you can listen to their tips, do your own research to make sure that what they say is based on fact and not just spun fiction.
It’s fine to listen to any and all advice, but don’t execute based on what stock marketers say. Do your own research. It’s worth the time and effort.
Never Stop Learning
Perhaps the biggest tip I can offer for success in the stock market, whether you’re investing in small-cap stocks or taking a totally different approach, is that you should never stop learning.
I established my Trading Challenge because I saw a distinct lack of valuable resources for traders out there.
I learned how to trade the hard way — there were no day trading classes when I was first starting out. But I don’t want you to have to learn the hard way.
My Challenge allows you to speed up the process of learning about the stock market so that you can get trading faster.
When you dedicate yourself to learning above all else, the market techniques will come in time. By creating a strong foundation of knowledge, you’ll be able to continue growing and adapting with the market.
The Bottom Line
Small-cap stocks can be risky, but they can also offer great potential rewards.
Less analyst coverage, less historical data, and a smaller scale makes these stocks more volatile, and therefore less appetizing to large institutional investors.
However, if you’re willing to put in the proactive research necessary to separate the up-and-comers from the underperformers, you can create opportunities for potential returns that you simply couldn’t find with large-cap stocks.
Have you traded small-cap stocks? Do you recommend it? Share your comments and let me know!