Trading FTSE Small Cap Shares

Small caps is the market terminology which refers to smaller companies. While a lot of the attention and the headlines go to the largest companies which make up the FTSE 100 and FTSE 250, the small cap part of the market can frequently be the most successful for traders. FTSE small cap shares are defined as those which are not in the first 350, the main indices, but still listed in the All-Share index. Of the FTSE ALL-Share index, which consists of about 630 companies, around 280 companies are classed as small with market values ranging from £390 million all the way down to less than £20 million. Cap refers to market capitalisation, which is the value of an enterprise when you multiply its number of shares by the present share price.

The next level down is covered by the FTSE Fledgling index, which is made up of about 220 shares. These range from £88 million to less than £1 million in value. Besides the FTSE Fledgling Index there is also the Alternative Investment Market (AIM); taken together these sum up to over 1,000 junior stocks although in practice they only make up 3% of the FTSE All-Share index taken by market capitalisation.

As we already noted there are about 280 companies making up the FTSE Small Cap index list, and often an economic recovery is led by the small companies initially. Certainly you cannot expect both the large and small companies to grow in tandem. This is for the obvious reasons that there is much more momentum involved with large companies, which find it difficult to change direction quickly in response to economic events. Academic studies even demonstrate that small-caps tend to outperform their larger brethren over the very long term.

As with the blue chip (larger) companies, these small companies also have an index that measures performance. You can expect that the spread on the Small Cap Index will be larger than on the FTSE 100 Index to reflect the volatility, but the spreads on indices in general are better than on individual stocks, and the figures are going to be fairly consistent across all brokers, leaving you free to concentrate on whether you think the market is going up or down. In fact, once you get down to the small cap level you may find it hard to spread bet on the individual stocks, due to their volatility. There can also be liquidity problems that would require your bookmaker to increase the spread to cover eventualities.

The other problem with trading small caps individually is that they can be thinly traded, and because of this the customary tools of technical analysis become less effective. If you are attracted by the volatility and scope for large moves that the small cap market can offer, then you are best trading the index, at least at first, before looking for individual stocks. Sometimes you will see the FTSE 100 showing signs of a recovery, but with little movement in the small cap and AIM markets. This is an indication that the market is not healthy, and that the apparent recovery may falter.

If you choose to spread bet on the stocks, then you should watch particularly for stocks making a new high, as this is more significant with small caps than with majors. Majors can make new highs because of the general market mood, but a small cap will usually have a good reason to go up. Because of the volatility, you also need to take a view on where you set your stop loss. You need to give the stock room to move to avoid being stopped out merely on the noise of the market.

A good way to set your stops is by referring to the previous action, rather than setting a percentage or set distance. The way the price moved previously will give you support and resistance levels, and if you set your stop just outside these you will be more in tune with the expected moves.

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It is important to keep in mind that small cap indices like the FTSE SmallCap and FTSE Fledgling suffer from the obvious disadvantage that their best performers are promoted to the FTSE 250. To make this even worse, companies which are having a hard time are also relegated to these indices (companies like HMV and Yell to name two!).

– Try to exclude the most risky shares – particularly the micro companies or the loss-making ones. The best companies are those with with cash in the balance sheet.

– Beware of the bid/offer spread i.e. the difference between the bid and offer price. This tends to be wider when it comes to small caps which makes it hard to turn a profit. A penny share with a 20% spread would have to appreciate 20% for you to breakeven.

– If buying look for companies that seems cheap compared to their trading history (even if going through a rough patch) but make sure they have low price-to-book and enterprise value to sales ratios. A low stock price doesn’t necessarily mean that the company’s valuation is low…

– Buy into companies where directors hold at least a 2% stake as this encourages management to focus on growing the company organically as opposed to acquisitions while keeping a strong balance sheet at the same time (crucial for small enterprises since running out of money can be fatal).

– Likewise, take special notice if management is buying. Director can’t buy all the time so they will buy when they they think there is good potential upside and they will tend to avoid buying if there is looming bad news.

– Look particularly at companies that enjoy high barriers to entry, which makes it easier for them to make a profit in the long term. This could be intangibles (say, intellectual property), or even an established distribution networks or guaranteed contracted substantial recurring income.

– The companies should be able to sustain themselves and make reasonable returns. For penny shares you should look at enterprises that look able to make at least 10% of the company’s valuation within three years.

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