In this article, we will look at how to make real money in the stock market by trading micro-cap US equities. We will follow three steps to make our buying/selling decisions:
- Define a Universe to create a watch-list
- Conduct technical analysis to narrow the watch-list
- Look at relevant headlines and industry developments
Now please don't be confused with the term micro-cap. I am not talking about your Wolf of Wall Street pink sheets, I am talking about real companies that are liquid, have earnings, and trade on an exchange. As well, this strategy isn't a day trading strategy. This isn't scalp trading. But rather, this is a swing trading strategy where positions are held longer than a day, and no longer than a month.
Defining Your Universe:
Now let's get to what to look for and how to find your "tenbaggers". Let's start by defining a stock universe. Some common methods for this are using sites like: value-line.com or finviz.com. However, my preferred method is to use TD Ameritrade's free trading platform: ThinkorSwim. So let's get to the actual screening criteria:
I like to make sure the securities I consider are liquid enough to trade, because if is no liquidity I won't trade it, and neither should you. So I choose an ADV of at least 100,000. Secondly, I like the total shares outstanding to not exceed 100mn so I know I can still get the outsized price movements I look for. I am really not interested in anything with more than 100,000,000 shares. I should also note that I would prefer to use the share float on here, but TD Ameritrade does not offer that feature. Lastly, I browse for stocks with a prior closing price of .50 to 5.00. These are somewhat arbitrary numbers, but from experience I like this range, and it limits the universe down a bit. The power of such low shares outstanding can be seen from the below:
Now that you have your universe, you will need to start to build a watchlist of tickers. Here comes the most time consuming part, you will need to drag these tickers into your stock analysis software (mine: ThinkorSwim's Charts feature). Essentially, in this step you will only be looking at graphs, and recent price movements. In this part, don't be concerned with what the company actual does or what kind of news the stock recently had. We only want to help further refine a watchlist then we will get into the actual analysis.
Looking for Chart Patterns:
First off, stay away from stocks with graphs like this:
These large price swings are really not what we are looking for. This is what traders might call "chop". Essentially, a stock like this just moves up and down with no real overall price movement in either direction. What we are looking for is a graph poised for a large price move.
Below are some examples of stocks we would want to add to our watchlist:
In this graph above, we see a price move from a low of 0.14 to 1.02. Anything that has this big of a movement should be added to your watchlist. Once you have your list you would want to see why the stock is up this high, and if the move is due to "fluff" news (does not really change the stock's fundamentals) or important news. If you were to conclude that this was really just fluff news, you would want to try and find shares to short.
In this example of BMTI, we see a clearly defined resistance level at the 2.72 price level. On this stock we would want to watch to see if price could break above this level with any significant conviction. On that same example, look at the gradual raising of the support level below.
The fact that this support level has gradually inched up is a good sign that we might be seeing a strong bullish price movement soon.
A good buy might be seen in the below graph. We saw volume kick in and cause a short spike, and then we saw a retracement back to a higher support level. The fact that price has found a consolidation at a higher support level is good news. As well, we can see price inching forward a bit, which could be the start of a huge price move.
Lastly, I'll just throw in a classic example of a pump-and-dump. Obviously you wouldn't want to get into something like this now. However, if you tried to play this price move a while back, you should have most definitely tried to find shares to short. The thing about price moves like this from around 1.00 to 10.68 is that these moves are simply not sustainable.
By simply looking for the types of graphs seen above you can create a manageable list of stocks to analyze further. The important thing to look for is clearly refined support and resistance levels for price. As well, things like volume, moving average crossovers, and RSI all help to make your decisions easier. I will briefly go into some technical indicators that might make your buying/selling decisions easier.
Basic Technical Analysis:
In this section, I will cover some basic technical indicators to look at that will help you make more informed buying/selling decisions. The first indicator will be the Exponential Moving Average.
I prefer to use an EMA vs. a traditional SMA due to the fact that the exponential average helps to reduce the lag by applying more weight to recent prices. In this method we will use what is known as a Triple Exponential Moving Average or TEMA. The three averages we will use are the 5, 10, 20-day (closing prices). Your graph will look something like this:
Once you have your graph set up, you will want to look for bullish/bearish crossovers. First off, you can see the general trend is up in the above by just looking at the 5-day EMA (light blue). However, you get a bigger picture by looking at where the lines are in relation to each other. In essence, when you see the shorter-term moving averages break above a longer-term moving average (acting as a support), you should expect bullish price movement. This is the opposite for bearish signals, where the shorter moving average crossing below a longer moving average would indicate a fall in price. See the below example for a bullish signal:
In the above picture you can see that once the 5-day moving average broke above the 20-day moving average, we saw a surge in price. However, crossovers like these are oftentime prone to whipsaws (a swing in price in the opposite direction). As such, a trader would have wanted to add this stock to a watch-list and once the 5-day EMA moved above the 10-day EMA, and once the 5-day EMA broke above the 20-day EMA the trade should have been placed. You would want to wait for the 5-day to break the other EMA to make sure that this price movement has some conviction behind it and isn't a short-term spike. A good short might look something like this:
For information definitions and further insights on moving averages, please see: http://www.investopedia.com/articles/trading/10/simple-exponential-moving-averages-compare.asp
The Relative Strength Index is used to identify if security is currently overbought or oversold. An RSI level of 70 means the security is overbought, and is likely to experience a short-term correction back to a normal price level. Adversely, an RSI level of 30 would mean the security is oversold, and should jump back up to a normal price level. Some traders may use 80/20 as their indicators, however, for the sake of their guide we will use the traditional 70/30. The first example I will use is a large-cap equity that has had some positive press recently: INTC
As you can see from the above, RSI spiked to a near 100 which gave us the stock high of 34.74. This would have been an obvious short for anyone that uses RSI. A stock overbought that much is simply not sustainable. As such, we saw a correction in the stock down to the 33.7 price level, and an RSI level of 75.1247. Looking more closely we see that buying/selling pressure has stabilized. However, this RSI is undoubtedly still to high, and while it may not be next week, this stock most likely will drop to a lower level.
For more information on RSI, please see: http://www.investopedia.com/articles/active-trading/042114/overbought-or-oversold-use-relative-strength-index-find-out.asp
For the sake of this guide, I will only go into detail on EMAs and the RSI indicator, however, more good indicators to look at are MACD and Williams %R.
Analyzing Your Watchlist:
In this section you will want to look at three things: recent news developments for each stock, upcoming announcements that may cause price movement, and industry developments. Now in this strategy, I really don't care about what the Free Cash Flow looks like, or what the EPS growth rate is, or anything like that. We are really only concerned with only indicator: price, and what is causing short-term price movements.
As you saw in our above examples, many stocks had these huge price moves from oblivion to the stars. What we want to find out is: is this fluff news or is does this news change the fundamentals of the company? For example, fluff news might be that there is speculation that the company is to be acquired by a Fortune 500 company. This might causes huge amounts of buying pressure, however, what is the likelihood of this acquisition? You will want to search around to find how valid the news source is. An example of news that changes the fundamentals of the company might be that the company won a favorable lawsuit that gives them royalties on a FDA approved drug. Whatever the case, find out if there is any news and if that news is fluff or not.
Next you want to see if the companies have anything in the pipeline for the future. For example, a stock like the below is hovering around a support level awaiting an announcement by the FDA on if a new drug will be approved approved. Whatever the case is, found out if there are any headlines that could affect the price of the stock significantly in the feature.
Lastly, you want to look at the industry that each stock is in. I like to have my watchlist set up like the below:
Really the only thing I am interested in in this table is the industry. I already have a good idea as to where the price, volume, and shares are due to my defined universe. The reason I want to know the industry is to see if there is any industry events causing buying or selling pressure. For example, if the price of oil has dropped significantly, you might see movements in E&P and oilfield service companies. Whatever the case, you will want to see if there has been any significant changes to the industry your companies operate in.
Once you have removed the companies that are up on fluff news, and have a sense for relevant industry events, you should be down to a strong list of stocks. Now you will need to channel your inner Zen and wait for the right opportunity to strike. Keep an eye out for stocks nearing resistance levels or crossing below support levels. As a trader you have a host of tools to help you as you choose which positions to enter. The key is to execute with confidence and patientence.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.