David and Goliath

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The ordinary trader can certainly be daunted by their opposition in the market. How can a small-time trader compete with large institutional investors, hedge funds and the banks’ propriety traders? The people on the other side of the trade have the best research, teams of analysts, the most up-to-date information and the quickest execution. Surely there’s no way we can win?
The answer, thankfully, is of course we can.
For all the advantages of big-time professional investors, there are plenty of factors that hold them back. The smarter smaller trader needs to be aware of these factors and try to figure out how to use them to their advantages.

Big or small?
There are a number of reasons why smaller investors might try to focus on the smaller end of the market. The major reason is because there are fewer large-scale institutional investors involved in this side of the market, there are more opportunities.
The reason large institutional investors stay away from this part of the market is because it becomes very difficult to buy and sell large amounts of stock. This means that these stocks are less liquid than larger stocks – and liquidity is all-important for institutional investors. If a large investors want to get out quickly, they are unlikely to do so without causing prices to move markedly. This results in these investors facing adverse price movement almost every time they enter or exit a stock.
While smaller investors face the same problem at time to time, it is by no means on the same scale. For larger investors, these smaller stocks are just not an option. With less influence from the larger investors, prices can often take longer to reflect news or changes in expectations. By the same token, smaller stocks are also more volatile – and this volatility can offer opportunity.

Which ones should you go for?
There’s a happy medium when it comes to stock size. Like Goldilocks’ porridge, the stock needs to be ‘just right’. While there are several definitions for what make a smaller company, at the least we can discount all the stocks in the top 100. The S&P/ASX Small Ordinaries Index, and many institutional fund managers, will classify ‘small companies’ as those companies included in the S&P/ASX 300 excluding stops that make up the S&P/ASX 100.
This equates to about 200 stocks, but in reality there are hundreds more, even excluding the microcaps and very speculative end of the market. As a rule of thumb, companies with a market capitalisation of between $50 million and $250 million probably qualify as “small cap” companies.

Corner the research market
The larger companies, especially the top 100 stocks, are all covered to the nth degree by the big broking houses. This result in a broadly consistent market view about the larger stocks. However, smaller stocks see much less research conducted on these companies.
This means there is a valuation gap at times between the company’s value and its share price. This can be exploited by savvy traders that do either their fundamental or technical homework. The slow realisation of investment communities as smaller stocks come on to their radar can also be beneficial. As more broker research is performed it brings more traders into stocks and this is another reason to try to get in early.

Trading the small caps
From a technical perspective, trading smaller stocks has both advantages and disadvantages. With fewer eyes on these stocks, trends can take longer to develop and give traders better opportunities to identify and establish trades. On the other hand, because of the lower liquidity, it can mean that larger players can affect the prices and throw you false signals. Longer term, trend-following indicators are best for traders looking to gain exposure to the smaller end of the market. These types of indicators include moving averages or the Parabolic Stop-and-Reverse system.

How to (and how not to!)
When trading smaller stocks, you are likely to have a longer expected holding period than you might when trading the top 20 stocks. With larger companies, traders are usually looking to take large leveraged positions and benefit from quick gains. But with smaller companies’ greater volatility, you might be looking to take fewer leveraged positions with wider stops.
The trader looking to gain the most benefit from smaller caps is therefore keen to stay in the trade for as long as possible. Therefore, using slower-moving averages, such as 50-day or 100-day moving averages, to determine trends and identify levels for stop losses can help you stay in a trade longer and reap the rewards of a multi-month move.
For technical traders, an easy initial screen of the market can be done by just looking at those stocks outside the top 100 that are making 52-week highs. Beware of stocks that are too small and don’t have enough volume for you to find it relatively easy to get in and out of stocks. Some experienced traders suggest traders avoid stocks that lots size of less than 20 to 50 times the size of your position. Additionally, many say to avoid stocks that don’t trade at least 1% of their overall issued shares each day. Other say to avoid stocks that trade under 50 cents or even $1 are better left to the more speculative punters.

Keep an eye out
Don’t forget the two best- performing stocks of the last decade – iron ore miner Fortescue Metals (FMG) and uranium producer Paladin (PDN) – were both minnows back in the early 2000s.

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