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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
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.