by Ian Harvey
July 30, 2019
Small-cap options trading has huge potential for the trader who is willing to take risk.
Small cap stocks are unlike any other stocks you've traded. They're closer to trading options than large cap stocks or ETFs.
Small-cap stocks can undergo wild-swings throughout the trading day – and 5% swings can be quite common – and predicting directional movement is near impossible at times.
Inconsistency is the only consistency!
Small-cap stocks are securities that are tied to companies whose market values often fall between $300 million and $2 billion. Small-cap stocks can be found trading on any exchange; although the majority of them are found on the Nasdaq or the OTCBB because of those exchanges' more lenient listing requirements.
Given their size, large-cap stocks are viewed by many investors as more stable and less risky, and often provide exposure to foreign markets as they sell numerous goods and services abroad.
Small-cap stocks, on the other hand, are perceived as less stable, more risky and more sensitive to the domestic economy, as they’ve yet to venture too far overseas. Consequently, their stock prices are a bit more volatile but can offer more potential reward.
Small cap stocks don't have a lot of shares in public hands that are available to trade on a day-to-day basis. So you can get wild swings in price, as there are not as many buyers and sellers at any given time. A low float can also be considered a low liquidity situation.
Less Analyst Coverage
The average large cap-established company will have dozens of Wall Street firms covering it. That leads to many opinions from those who have researched the company. They cover companies for two reasons. The first is in hopes of garnering future investment banking business. The second is to try and develop a following through good track records. Not having coverage can lead to significant gaps in news flow from sources outside the company, and that can lead to small cap blackouts. Rumors can move prices much more than facts.
Lack of News Coverage
Small caps don't have a lot of money for big public relations or investor relations departments. That leads to a lack of news.
Not having much insight into a company can lead to wild trading in the shares, as investors tend to react and overreact to news that might be scarce or opinions that might be inaccurate from sources not affiliated with the company.
When there is legitimate news, the shares can move up or down by double-digit percentages in a single day. For small cap biotech stocks, this can be magnified even further on good or bad news about a promising drug or trial.
An options trader must consider the amount of volatility and lack of liquidity when using small-cap stocks.
Also, as small-cap stocks see more day-to-day volatility, their options tend to trade at higher implied volatility levels than those that are more seasoned stocks.
Many small-cap stocks are illiquid; and many low-volume stocks will not have options listed on them. And, when they do, the options aren’t the most actively traded.
This situation leads to wide bid-ask spreads, which makes it difficult to buy or sell when desired; therefore, limit orders are recommended.
Trading options on small-caps could be a good idea, especially if the trader has a “risk-on” attitude, and is pursuing higher returns.
However, small-caps are not for everyone. They are very volatile, and as a result, their trading often scares investors out of a position thanks to wild moves, especially moves lower in price that can happen on no news or company-specific events.
Trading small-cap options…..
Small caps have huge profit potential. Any good news can magnify upside moves - and the opposite is just as true. Being selective in what you buy is important. Look for catalysts like insider buying, potential deals with larger companies, clinical trial results and more. But remember, small caps don't trade like normal companies. Therein lies the risk... and the rewards!