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Shark School of Trading: How to Trade Small-Cap Stocks in a Poor Market

These names can be hit very hard regardless of their fundamentals or merits. Here's how I navigate these risky waters.
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The market is choppy Wednesday as it digests further comments from Jerome Powell and evaluates Jobs Opening news for clues as to whether the Fed will hike rates 0.5% or 0.25% at its meeting on March 22. Upcoming jobs news on Friday and the CPI and PPI reports next week will be the determining factors. In the meanwhile, the market is choppy and uncertain.

This sort of market action offers an excellent opportunity to discuss how to handle thinly traded small-cap stocks. I tend to favor smaller stocks because they are often inefficiently priced and have the potential for much bigger moves in the right market conditions. But they also have much higher risk and can be hit very hard in a poor market regardless of their fundamentals or merits.

I maintain a long list of small-caps that I believe have solid fundamentals in the long run and are not currently appreciated by the market. These names include Beyond Air (XAIR) , CECO Environmental (CECO) , Origin Materials (ORGN) , Magnachip Semiconductor Corp. (MX) , Xeris Biopharma Holdings (XERS) , Sensus Healthcare (SRTS) , Ocular Therapeutix (OCUL) , and several others.

These stocks have had one similar characteristic in the current market -- they have not been able to develop sustained uptrends even when they have positive news. Often, a spike on good news is viewed as an opportunity to sell, and the stock ends up lower as it awaits another positive catalyst.

The problem is that it is difficult to know if there is some operational shift at the company or just market conditions. If market conditions are the problem, then there is the further question of how low the stock can drop in a poor market environment.

I deal with this by trading the stock in very short-term time frames to take advantage of the typical volatility. My position size will shift dramatically over time. The primary goal is to have room to buy more shares on market weakness. To do this, I have to flip into short-term spikes but then stay ready to become more aggressive should market conditions shift or a sustained rally in the individual stock develops.

A good example recently is XAIR, one of my top picks for the year. The stock had a nice run into its earnings report but sold off due mainly to a lack of solid sales forecasts. The stock went back under $6, which is where insiders have bought, and that appeared to be a good position to remount some shares sold into strength. I continue to look for entry and exit points during the volatility that should occur while waiting for the next positive catalysts.

The key to this approach is to understand the stock that you are trading and to have some appreciation of potential news that may move it. When market conditions are poor, these stocks are the ones that will become the best values as they are mispriced. It requires patience, and there is high risk, but when market conditions shift, the gains can be considerable.

(Please note that due to factors including low market capitalization and/or insufficient public float, we consider these names to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.)

At the time of publication, Rev Shark was long XAIR, CECO, ORGN, MX, XERS, SRTS and OCUL.