Editor's Note: Small caps have a tendency to outperform their large-cap brethren this time of year, which is why we're featuring Sid's strategy today. His method can help you find the risk-reward balance that's so crucial to successfully trading these promising but volatile stocks. Here's Sid...
History is literally chock-full of compelling examples of small-cap stocks delivering 1,000% returns to shrewd investors who got in early.
With those kinds of returns possible, it's no wonder investors are so excited by small-cap stocks.
Unfortunately, though, in many cases that same excitement leads less disciplined investors to throw away all sense of risk management and proper portfolio structure in the pursuit of outsized gains - and that's a big mistake.
For every story of a $5.00 stock exploding and becoming a $50.00 stock, there are countless examples of companies flaming out, leaving investors with worthless shares.
That's why it's so important to have a risk management strategy in place - and one that's tailored for small-cap stocks.
That way you can seize the great opportunities for massive wins... and still sleep easily.
Don't Get Stopped Out... from Explosive Growth
Standard risk management techniques such as percentage-based trailing stops are excellent ways to manage risk with higher-priced stocks that typically exhibit lower volatility - but small-cap stocks, especially those priced under $5.00, can experience wide-ranging price swings as part of their normal trading range.
Those wide price swings can stop out investors using standard percentage-based stops - often times leaving investors on the sidelines just before the stock reverses and takes off to the upside.
If you're comfortable with getting stopped out a few times (and there's nothing wrong with that strategy) before your investment takes off to the upside, then a traditional percentage-based or dollar-based stop is probably just the ticket.
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On the other hand, if that sounds like too much work and you would rather establish a position with a longer-term horizon, then the obvious question is: How do I manage my risk without the use of a protective stop?
My first choice here would always be the use of put options.
Unfortunately, sometimes the small-cap company you're interested in won't actually have any put options available, or the premium (price) is so high that it makes using put options prohibitive. When that's the case, I think one of the best strategies is to simply use a price-based risk-reward model.
To use a risk-reward model, the first thing you need is a future price estimate of where you think the stock could trade. That estimate could come by way of technicals, fundamentals, analyst estimates, or any other methodology you feel comfortable with.
A standard among many professional traders is to only enter a trade if the potential reward is 2X the risk. That way they only need to be right 50% of the time and they'll still make money over the long term.
Another standard shared by many professional traders is to never put at risk any more than 1% or 2% on any given trade.
I'm going to circle back to those two standards and how to implement them with mid-cap and large-cap stocks in just a moment. But for now, I want to focus on how you can use the risk-reward model with small caps.
Here's How It Works
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For the sake of easy math, let's assume you have a $100,000 portfolio. If that's the case, then 1% of your investable capital represents $1,000. That means you would risk no more than $1,000 on a single position.
Now let's assume that the stock you're targeting is currently trading at $2.50, and your analysis indicates it could be trading at $7.50 within the next 24 months. That means your potential profit of $5.00 ($7.50 future price - $2.50 original price = $5.00 profit) is 2X greater (a 200% gain) than your initial investment.
Following along with the initial assumptions, you could purchase 400 shares at $2.50 and have a position worth $1,000 - or 1% of your investable capital. Now, just sit back and wait out the 24-month holding period. This strategy will keep you in the position no matter what kind of volatility the stock experiences, and your risk will be capped at 1% of your overall investable capital.
Note: I used a 24-month holding period merely as an example. Every investment time frame is going to be different. Generally, though, in the case of small-cap stocks, I prefer holding periods between 12 and 24 months. That gives me enough time for the stock to absorb any short-term volatility.
If the stock performs as planned, your position will increase in value to $3,000, you'll be sitting on $2,000 in profit, and your investable capital will have increased by 2% - all on just one trade. On the other hand, if after the 24-month holding period the trade is a dud, then you can sell the position and know that you only ever had 1% of your capital at risk.
I'm sure somebody reading this is thinking: Whoo-hoo, my portfolio just gained 2%, thanks for nothing. Or maybe they're thinking: That's fine and dandy if I only have one small-cap company in my portfolio, but I have 20 small-cap stocks, so I could potentially experience a 20% drawdown if they all go bust.
If you're using a risk-weighted portfolio structure similar to the 50/40/10 model pioneered by Money Morning Chief Investment Strategist Keith Fitz-Gerald, then you would confine your small-cap position to what we refer to as the "Rocket Riders," which represent 10% of your overall investable capital.
In the worst-case scenario, the biggest drawdown you could experience (based solely on your riskier small-cap stocks) is just 10%. On the other hand, your upside is far greater...
Using the example and assumptions above, your overall investable capital could increase by at least a 20%... and all from just 10% of your overall capital. The remaining 90% can be used to invest in high-quality income-producing stocks, bonds, and ETFs that round out the other 90% of the 50/40/10 model.
If you're not familiar with the Money Map Press 50/40/10 portfolio structure, take a moment to read this overview.
Merging Risk Strategies to Keep Your Upside Intact
Now I want to circle back and discuss how you can merge the same ideas with traditional percentage-based or dollar-based trailing stop strategies, which are especially useful when you're targeting mid-cap and large-cap stocks.
Let's continue with the previous assumption: $100,000 of investable capital and $1,000 (or 1% on investable capital) at risk.
If you plan on establishing a position using a 25% trailing stop, then you could actually establish a $4,000 position (or 4% of your investable capital). If the stock pulls back 25%, you'll have lost only $1,000, or 1%, of your investable capital.
If a 25% trailing stop seems too wide, you can simply adjust the numbers to fit your risk tolerance. The key here is to make sure you have a risk-reward strategy in place "before" you actually establish a position... so you can reap the massive gains small caps have to offer...
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About the Author
Sid is the investment community's best-kept secret. Since 2009, he's served at Money Map Press as Director of Research, analyzing thousands of securities and profit opportunities for subscribers. He's an expert in identifying "alpha" potential in a wide variety of industries, but especially the small-cap sector, where he's discovered a pattern of profits that's almost foolproof.