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Small Caps: Trading Strategies and Tactics

- By Robert Abbott

To increase the odds of succeeding with small-cap stocks, Ian Wyatt recommended not only smart analysis of target stocks, but also knowing the trading system and having a keen sense of timing. Those issues dominate chapter seven of his book, "The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks."

Liquidity


While large caps may have millions of buyers and sellers, it's much lonelier in the small-cap world because relatively few shares trade among relatively fewer investors. When Wyatt wrote this book in 2009, Alphabet (GOOG) had 240 million shares outstanding and a market cap of $100 billion. Small-cap Graham Corp. (GHM) had just 10 million shares outstanding and an $89 million market cap. Graham was trading 181,000 shares per day, compared with 5.5 million shares for Google.

Graham's lack of liquidity also meant share prices would be inherently more volatile. Relatively small orders for small caps can push prices up and down dramatically.

To compensate, Wyatt offered several strategies and tactics.

Order types

He outlined nine types of orders available to investors:

  1. Market orders: The conventional order format, instructing your broker to execute your order right away at the current market price; these orders can be difficult for small-cap investors since volatility could lead to higher-than-anticipated prices when buying or lower-than-expected prices when selling.
  2. Stop-loss orders: A loss-limiting tactic, it instructs the broker to sell if the stock falls to a predetermined price. These should be used cautiously since daily volatility could "stop-out" a position. Also, in a fast-moving market, the selling price could be significantly lower than the investor expected.
  3. Trailing-stop orders: Preserving paper profits is the goal for this tactic, with the stop representing a fixed percentage of the current market price. If the stock slips back by the set percentage, it is automatically sold.
  4. Limit orders: Instructs your broker to buy only if a specified price point is hit. Wyatt called this a smart way to buy and sell small caps--for those prepared to patiently wait for their target price.
  5. At-or-better orders: This is a variation on limit orders, specifying that the broker should buy at or below the price limit; sell orders would apply to prices at or above the price limit.
  6. All-or-none orders: Often used with "combination orders," involving both stock and option positions, and meaning the broker should buy neither until both can be placed at targeted prices. A covered call is an example.
  7. Good-till-canceled orders: The order remains open until it is executed or you cancel it. Again, this is helpful for small-cap investors willing to patiently wait for a price. On the sell side, it can be used in combination with a stop loss.
  8. Day orders: All orders except for "Good till canceled" are effectively day orders, meaning they automatically expire at the end of the day if not executed.
  9. On-close or on-open orders: Executed just before the close of the day, or at the open on the following morning.



Risk

As noted, small caps can be volatile and, therefore, risky. Wyatt argued, though, that these risks are manageable with the proper order formats, diversification, proper timing and averaging techniques. He also advised there are various types of risk:

  • Market risk: What the stock market as a whole can do to the prices of any given stock.
  • Liquidity risk: You're not able to sell your stocks for the prices you want or expect.
  • Cash-flow risk: A problem connected with leverage, or buying with borrowed money.
  • Diversification risk: Owning too few or too many different positions.
  • Economic risk: An economic downturn can affect the values of companies.
  • Knowledge and experience risk.
  • Tax and inflation risk: Wyatt said, "Taken separately, they may seem relatively benign. But together, they can be disastrous."



Timing decisions

Wyatt offered tactics for making good timing decisions:

  • Set profit goals and bail-out points in advance.
  • Decrease holdings after a profitable run-up, or take profits on some of your position and leave the remainder to ride with what appears to be a continuing trend.
  • Use trailing stops to control potential losses, or set a floor on possible losses.
  • Review and re-review the fundamentals regularly. This is especially true for small caps, which can change directions or change the business model.
  • Watch for the leveling of trends: No trend continues forever, and it helps to be aware of the leveling before other investors.
  • Track moving averages and other buy-sell signals. Wyatt pointed out that the use of averages offsets short-term price volatility. In the previous chapter, he offered a three-part timing strategy.



Stock options

Paper profits can be protected with the use of put options, which increase in value when the underlying stock price falls. Consider it insurance on an asset. On the other side of the coin are call options, which increase in value when the price of the underlying stock rises.

Wyatt warned that options are highly specialized, so investors need to "master the complexities of [the options] market" before using options.

Dollar-cost and value-cost averaging

The first of these, dollar-cost averaging, is buying or selling over time, rather than all at once. For example, investing $1,000 per month for 12 months instead of paying $12,000 once. It is normally done on a regular interval, such as weekly, monthly or quarterly. This works in both rising and declining markets.

Value-cost averaging involves adjusting the amount invested each month (or other period), depending on how the stock performs. For example, if the price is declining, then fewer shares would be purchased.

Summing up, in chapter seven of "The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks," Wyatt explained that small caps tend to be illiquid, leading to more volatility. To cope with this volatility, investors should use appropriate trading methods and timing strategies.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.