Trading Lesson of the Week

Check back weekly for another free trading lesson:

Does Size Matter?

In This Week’s Issue:

  • Stockscores’ Market Minutes Video – The Morning Stair Master
  • Stockscores Trader Training – Does Size Matter?
  • Stock Features of the Week – Profiting from a Correction

 

Stockscores Market Minutes – The Morning Stair Master

Stocks are making most of their move in the opening hour and then going sideways for the rest of the day. There are some situations where stocks will trend all day long. I discuss this, my market analysis and the day trade of the week on PFE in this week's Market Minutes.

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Trader Training – Does Size Matter?

Investors often group stocks by their market capitalization, the total value of the company based on the price of their shares multiplied by the number of shares outstanding. Microcap stocks might have 20,000,000 shares out with a price of $0.50 - these tend to dominate the TSX Venture Exchange. A company with a few hundred million is more of a real business but still considered a small company compared to the large cap stocks that dominate the major market indexes, each valued at many billions of dollars. Apple, currently the largest company listed in North America, has a market cap of $865 Billion.

There are significant differences in how stocks small cap stocks trade compared to large caps. It is important to understand these differences so you can approach trading them in the right way. Here are some things to consider:

Liquidity - liquidity is a measure of how actively a stock trades and how smooth the price movements are for a stock. Generally, large cap stocks are more actively traded and make less volatile changes in price. Small cap stocks don't have as many investors which makes them subject to a higher level of price volatility. This means that the reduced liquidity of small cap stocks makes them riskier. A stock that does not trade actively can make big price swings because of the actions of one large investor.

From a practical standpoint, this means you can suffer a bigger loss than you plan for in your risk management. You may plan to exit a trade if the stock hits your stop loss point at $5. However, if the stock is not very liquid and many investors try to exit at the same time, you could end up getting out at a much lower price than what you had planned for.

Correlation - every stock has some correlation to what the overall market is doing. If the general market is going up in value, most stocks will also go up. Large cap stocks tend to be more closely correlated to the market index. If you look at a chart comparing Microsoft (MSFT) with the Nasdaq 100 (QQQ) you will find that they move all most exactly the same way.

This makes it important to analyze the market index as well as the stock when considering the purchase of large cap stocks. Even if the large company you are considering is doing great things in its business, it may not perform well if the overall market heads lower.

This also means that large cap stocks can outperform small cap stocks when the overall market is strong. We have seen this over the past year; small cap stocks have been flat while the large cap stocks have moved in a strong upward trend with the overall market.

If the overall market breaks its long term upward trend, we may see money look for market beating returns in small cap stocks because this group is not so closely correlated to what the overall market is doing.

Performance - small cap stocks have a greater capacity for percentage return, up or down. Smaller companies tend to have a less diverse business which means they can go up or down rapidly based on the performance of their products or services. Consider how a company making a smart watch would do if it was successful. For a company like Apple, the launch of a smart watch might bring in a few billion dollars in sales but that, in the context of their overall business, will not have a huge impact on earnings. If a small cap company had the same success with the same product (and it was their only product), the effect on their stock price would be massive.

Of course, the failure of a business can also have a huge effect on share price. We often see small cap biotech stocks suffer painful and sudden sell offs when a drug that they are developing fails to get approval.

This defines the risk reward trade off that comes with selecting between market caps when investing. Large stocks have a hard time significantly beating the overall market. Small caps can achieve this but they can also suffer significant losses. With smaller cap stocks, risk management is more important.

Yield - many investors like stocks that pay a dividend since they rely on their portfolio for income. Most small cap stocks are working to grow earnings and use their capital to reinvest in their business. Once companies get large, they begin to return their earnings to shareholders as dividends. If you want to collect dividends, you will generally focus on larger cap stocks.

Fun - historically, I have found that trading smaller cap stocks is more fun. It is enjoyable to buy a stock at $5 and watch it go to $10 in a few days. That can happen with small cap stocks, it is rare with large cap.

Of course, making good returns is always going to be fun and you ultimately have to go to where the trend is strong. Large cap stocks have been in an upward trend for a number of years making it likely that any investor in boring, large cap stocks has felt pretty good watching them go up, even it has been slow and steady.

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