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define small cap stocks

How do we define small cap stocks? The generally accepted definition is a stock who's market capitalization is $250 million to $1billion. Unfortunately, that definition doesn't explain why small cap stocks are so popular.

For the new trader, or someone with a small portfolio, small cap stocks can appear to be the perfect investment.

Small Cash Investment

Since the majority of small cap stocks trade below $5 (with many trading sub $1 - thus the popular term penny stocks), its easy to create a diversified portfolio of small cap stocks. On the plus side, it doesn't take much momentum to produce 50%-100% gains. The downside - it doesn't take much to lose 50% of your investment if someone dumps their shares in a hurry.

The Next Big Thing

Who wouldn't want to be able to say they got into the next big stock - its all about the bragging rights. Further, if you got into a company at $0.10, you make back your initial investment each time the stock moves up $0.10 - that's awesome if the stock is now trading at $5.00 a share and more.

No Institutions

The majority of mutual funds have rules in place that do not allow them to own stocks that trade above $5 - that means you dont have to worry about an institutional investor dumping their shares, dropping the share price dramatically.

Its All About The Size

Don't forget - small caps are not just anything that trades under $1 - there are microcaps and even nanocaps that you can trade - just keep in mind that they are typically not very liquid - making it tougher to accumulate a position, and more importantly, get out of a position. You may want to check to see if they are also trading as a pink sheet - typically nanocap and microcaps stocks are priced at that level for a reason: poor financials - and that is assuming they are even reporting them.

There are approximately 1600 small cap stocks to choose from - providing you with plenty of choices. That said, only 350 or so trade with a 50 day average volume of 500 000 - still, plenty of good choices. Remember, small caps have historically outperformed larger caps.

Some Caution

You may find that some small caps are not start ups - instead, are former large caps - stay away from these former glory stocks - you want companies who not only have a good idea, but have a growing customer base (who of course are spending money on the company's products). Look for growth rates of at least 20% and at the very least, positive EPS.

Volume will continue to be your biggest challenge - stick with stocks where the average volume is 500 000 and you wont have to worry about dropping the bid price too much when you sell for big profits.

Remember, whether you call them penny stocks, nanocap stocks or small caps, these are risky investments and should only take up a very small portion of your overall portfolio.

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