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Why small caps can help you profit when big business can't

WITH so many blue-chip stocks&rsquo; share prices plunging to penny stock levels, it is small wonder that the FTSE 100 companies are no longer the relatively safe trading bets that they once were. And these sprawling multinational companies have found it difficult to become leaner operations in the face of declining global demand.<br /><br />It is not surprising then that contracts for difference (CFDs) traders have been turning to the smaller growth companies that populate the lower echelons of the London Stock Exchange in search of bigger profits.<br /><br />Small cap stocks can be extremely volatile, especially on the back of company news, which can mean huge profits for leveraged CFD traders. Many of these businesses are resource exploration companies or biotechnology companies trying to develop the next wonder drug, so any positive announcement can see the share price surge a couple of hundred per cent in one day.<br /><br />However, CFD traders looking for quick profits from small caps will be sorely disappointed &ndash; approval of a new drug can take years, as can drilling oil wells. This means that CFD positions on small caps tend to be held for longer than average as traders wait for these developments to occur and feed through into the share price.<br /><br />In the past the small cap market was seen as highly illiquid and not profitable but it has changed tremendously over the past few years, says Manoj Ladwa, senior trader at CFD-provider ETX Capital. &ldquo;What you had before was a lot of momentum traders but the increase in liquidity means you have got sustained trends and this allows clients who want to trade small caps in large sizes without worrying about liquidity.&rdquo;<br /><br /><strong>LIQUIDITY LAG</strong><br />However, the liquidity still lags far behind that seen in the leading UK companies. While the lower liquidity levels can make it difficult for CFD traders to unwind their positions, Rob Pike, head trader at Spreadex, says that this in conjunction with high volatility can give canny investors opportunities for spotting a share that has been beaten down dramatically, and to execute a well-timed buy to take advantage of a pending rebound.<br /><br />A lot of small cap stocks have indeed fallen by the wayside during the financial crisis &ndash; some terminally so. But this is a good thing, says WorldSpreads&rsquo; Omer Bhatti &ndash; it means that the average quality of those companies remaining in the market is much higher than it was before the crisis and those left are more likely to succeed.<br /><br />Ensuring you pick the small caps with the best upside potential is partly a question of luck but it is also a matter of thorough research and staying on top of any business developments. Successful equities trading always requires research but it is even more important with small caps because of the way the smaller companies are structured &ndash; they only have one or two products on which their profits are reliant. GlaxoSmithKline&rsquo;s share price can fall 5-10 per cent if one of its many drugs fails a trial, so imagine what a failure can do to a small cap.<br /><br />However, most AIM-listed companies will be trading in the low pence rather than in the pounds, so if a firm&rsquo;s share price does crash it means that punters would often face smaller losses on strategic buys, rather than 100 point-plus losses on their investment in blue-chips.<br /><br />But the lower liquidity and high volatility means small caps are subject to higher percentage margin requirements, something to bear in mind when considering jumping into a trade. But a 20 per cent deposit requirement still gives five times leverage, which demonstrates the benefits of CFDs compared to direct investment in the company.<br /><br />If you&rsquo;re prepared to put in the time to do the research, then small cap CFD trading can be an extremely profitable and much more interesting alternative to taking out a CFD position on your typical blue-chip stock.