Small cap vs. blue chip stocks: two different approaches

Investment in small-cap stocks requires a different approach than traditional investment in blue-chip stock markets. Companies are different, dynamics change, and strategies cannot be the same.

Investment strategies for small companies will be different from those of large companies. When you buy blue chips, you have to do different valuations than when you buy small caps.

In this analysis, I’m not going to consider investing in equity indices, ETFs, or investment funds, but only in simple buying and selling individual stocks. In fact, the stock indices have different characteristics, but they behave similarly.

The S&P 500, which includes the largest US stocks, will perform differently from the Russell2000, which includes small caps. The first index will react more violently than the second and behave differently in the various economic phases. 

But when you compare Apple’s stock (AAPL 144.50 – 2 trillion market capitalization) with Evoke Pharma (EVOK, $ 3.48 – 39 million market capitalization), things change.

Apple may have some ups and downs in the short term, but Evoke Pharma’s price movements won’t be comparable.

small cap vs blue chips - apple vs evoke Pharma chart volatility - LukkVal
TradingView: small-cap vs. blue-chip – Apple vs. Evoke Pharma chart volatility

We should change the way we invest. First off, we need to work on money management. The position size changes continuously according to the stock’s volatility and riskiness.

A stock can be volatile but not risky because its failure is unlikely due to its fundamentals—anyway, the more volatile the stock, the lower the investor’s risk to the market. 

We can compare the purchase of BitCoin and DogeCoin, which are popular right now. Bitcoin could double or halve in the medium term; Doge could double in 20 minutes after Elon Musk tweeted.

Some thoughts on equities

In this paragraph, I’m going to talk about some concepts that are considered obvious to many. If you’re familiar with the stock market, you can skip to the next section.

The main difference between stocks on the stock market is based on their capitalization. Bigger companies have bigger capitalizations, which means more shares in the market.  The larger a company is, the more trades it does each day, and the more liquid it is.

The most capitalized US stocks are placed in thousands of financial instruments, including ETFs and investment funds. Large investors usually hold blue-chip stocks for the long term, so they’re less susceptible to short-term trends.

I am not saying that blue chips can’t collapse or cause significant losses. It happened, and it’s going to happen again. But it’s less likely to happen, and with rare exceptions, the downward movement is reversed. 

A piece of news about a low-capitalized stock can cause it to collapse or soar, but if capitalization exceeds $1 billion, it will have less impact. 

Small caps can lose huge amounts of money or go out of business in a few days if some big investors decide to sell their stock.

A less liquid market is more easily manipulated. A less liquid market is volatile because even a medium-sized hedge fund can move the stock with their trades.

Large-cap stocks are stable and low-volatile; that’s the most important thing. Big investors provide liquidity, so the price will generally be pretty stable. A single hedge fund can’t manipulate the price of a blue-chip by itself. 

Small caps vs. blue chips and money management

The first thing you need to consider is money management. The smaller the capitalization of the shares, the less you have to invest in monetary terms.

It’s easy to imagine a share going from $3 to $9 in less than a week, while we rarely see Microsoft triple in value in less than a week. We’ll have to make the same arguments for downward movements.

Let’s say you want to invest in stocks without buying an ETF or equity fund, but you still want to create your own portfolio. Buying the ten most capitalized US stocks will probably track the movements of the S&P500 index or SPY.

S&p500 index vs Russell2000 volatility - LukkVal
US500 vs. RUT – S&P500 and Russell2000 index

Instead, attempting to replicate the Russell 2000 with ten small caps is a real challenge. 

Long term investors

Investors with a long-term time horizon will invest more significant sums in blue chips because they’re more stable and use a small part of the portfolio to bet on small caps. 

Blue chips also have different volatility, and you need to manage your money accordingly. On the other hand, it’s easier and sometimes sufficient to use the Average True Range.

Money management also means risk in terms of profit. A blue-chip is a low risk, but it won’t return much potential. You usually don’t risk overnight buying Apple, but you won’t triple your money in a few months. 

Investing in small caps is more of a speculation than an investment. So use small amounts of capital in the hope of making considerable gains.

Technical analysis of small caps vs. blue chips

Sometimes technical analysis of blue chips makes sense. If there are many institutional investors, a 200-day moving average can cause the price to react more predictably than with a small-cap stock.

Support and resistance levels are longer lasting because big investors defend those price levels before they expire.

Even overbought and oversold areas make sense when using RSI. When the market is in extreme RSI zones, institutions tend to leave or enter the market. Also, many algorithms based on these models make everything more predictable than in the small caps market. Using RSI to analyze a small-cap trade is not useful.

top 10 companies by market capitalization from 1996 - 2020
Image from i.ytimg.com

Technical analysis of a small stock is pretty much worthless, except in a channel breakdown, followed by a price increase. Small stocks that break out start trending rapidly because they’re not very liquid.

The volumes in small caps are much easier to read because it’s easy to compare volumes with price movements. But this kind of analysis is also pretty weak and obvious. 

I think some people overestimate the accuracy of technical analyses. There are cases where it works, others where it is useless. I don’t think it’s handy for predicting price trends. I usually use it to support other arguments and optimize the entry timing. In my experience, many strategies aren’t statistically significant in the years I’ve been creating automated systems.

Charts can be deceiving, and the human mind is structured to create cognitive biases that value things that don’t exist.

Intraday trading and overnight gap

I’ve already told you I wouldn’t say I like intraday scalping. I think it’s a huge waste of energy, but it might make sense to trade small caps.

A small-cap stock could potentially lead to big intraday moves so that an intraday strategy could be profitable. The more price moves, the more potential profits increase; therefore, commissions affect a tiny part than earnings.

You should buy on a breakout, hold the trade and try to make as much money as possible before the market closes. So I’m talking about intraday trend-following strategies, not scalping.

Because small caps are risky and subject to big movements, intraday strategies can also help avoid big overnight gaps.

Blue chips also have gaps in the after-hours. Stocks often move more in the closed market than they do during the day. But these gaps are rarely too high and usually get reabsorbed. 

I’d undoubtedly use mean reversals if I wanted to trade blue chips intraday, but the profits are low. This kind of strategy would be like scalping, and I don’t see it as valuable in the long run.

However, many traders trade blue chips intraday with acceptable results. I wouldn’t say it’s impossible. It takes a lot of patience and mental toughness, which few have.

Trend-following and mean-reverting strategies

In the early days of online trading, the most important strategies were trend-based. Today, many “guru traders” only use a 2:1 or 3:1 profit and stop-loss ratio. They usually forget to tell you that it only works with trend-follower strategies. 

Trend Following Strategies

This strategy uses the trend to make as much profit as possible. You’ll have to take a bunch of small losses waiting for a big win.

These significant directional movements are no longer present in almost all of the more capitalized stocks in the intraday sessions. Trend-based strategies require a lot of volatility and a clear direction. We can certainly use a trend-following strategy to invest in the long run. The stock market has gone up for years, and anyone who’s stuck with it has made a profit. 

But the most heavily capitalized stocks tend to respond better to mean-shift strategies in the short term. Blue chips tend to retrace their upward or downward movement after a price move, while small caps tend to continue their run.

We can use trend-following strategies on both blue chips and small caps with a long-term investment view. At the same time, I’d only use an indicator like the RSI on indices and shares of the S&P 500.

Mean reverting strategies

Mean reversal strategies on small caps are useless because they rarely work.

The RSI, which identifies over-bought and over-sold zones, should not be considered in individual small caps. A small stock that has soared and tripled its value in an overbought area can continue to go up. Using the same logic, it makes no sense to buy a small business because it collapses and loses 50% of its market value. It might be helpful to buy a stock like Apple after it loses 30% after a news story or global market crash.

Short selling strategies

I would never short small caps. I wouldn’t say I like it with blue chips, but sometimes I use it to cover myself in a short time.

Also, I can use it to create spreads, like buying Microsoft and selling Apple. Anyway, compared to small caps, the risk of shortening a blue chip is relatively low. I’ve told you several times that a small stock can triple its value in a matter of days, while it’s impossible to stock the S&P500.

The advantage of small caps is that you can lose everything, but you can also make a lot more money. Anything can happen. A small company can grow over time and be worth 100 times more. We risked 1 to 100, which is a rare but likely event. It’s clear that short selling is a meaningless decision: we risk 100 to earn 1.

Putting on a spread between two small caps is also very risky since small stocks move most of the time independently of the global market and indexes.

Google, Johnson & Johnson, and Berkshire Hathaway generally follow the global stock market. When the stock market crashes, the big stocks tend to fall more or less violently, but they fall. A small cap could trend up during a crash or crash during an uptrend. 

Influence of news and social media

News can affect the stock market, but not all news has the same impact and can create a long-term trend.

The more company is capitalized on; the less news affects the long-term trend. Many times catastrophic news about Apple coming out, but it’s always there that rises non-stop. 

But when bad news hits a small-cap, things change. In general, the price movement will be more intense and lasting; several reasons for this.

Related article: Can Reddit beat Wall Street’s hedge funds?

Fewer deceptions are created because not many big investors are interested in small stocks. Furthermore, few institutional subjects run to help in a stock collapse because they have no interest in doing so. 

The lack of options makes it even more volatile and dangerous, as there’s no protection for investors.

Small traders and small funds will react to the news, so there won’t be many large counterparts holding the price, so there will be high volatility, and the price will fall quickly.

Even social media can move a small stock and create a group on Reddit. A small-cap can be raised or lowered by a group of people, but a blue chip can’t be.

reddit wall street bet and gamestop

It happened before, and it’ll happen again, and you can make a profit by following these sudden little trends. The problem is always predicting the right exit time, but it doesn’t matter whether the trend is strong.

Conclusions

I tried to compare two different investments in this article. Two financial products that respond to a different logic and must follow different rules and arguments.

Never buy single stocks, and always have a portfolio of different companies. The best option is to invest in equity indices or ETFs tracking an index.

You might find that trading small caps is fun, but never short them and use a trend-following strategy.

There are thousands of small caps, and monitoring them all is impossible. It would help if you had software that filtered certain parameters. Some services provide information on the most commonly quoted small-caps on social media to understand where private traders are heading.

I buy small caps, build a relatively broad portfolio and remain indefinitely in the investment. My maximum risk is the entire capital invested in every single small-cap, so my single position size is tiny. It is only a personal decision and a way of investing.

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