Although it would be nice to say that I’m going to publish a thought-provoking blog post every week, that’s not the reality. Sometimes there’s simply nothing interesting to say and I’m not the type of person to write something for the sake of clicks or a predetermined publishing schedule. But, on the day when there’s something interesting to say, I will write about it.
Today is that day.
Now, it’s debatable whether it was first the pandemic that drove thousands of novice traders into the market, or perhaps Robinhood’s gamification of trading on the phone or maybe the meteoric rise of Gamestop, which attracted the gaze of algorithmic hedge funds to small caps. It doesn’t really matter at this point, but one of those events or perhaps a combination of all of them, created a different market for seasoned small cap traders who were already trading prior to 2020. For one, we are in a different economic environment. Additionally, many of the small cap stocks, which are biotech startups, are reeling after being grossly overvalued during the covid run-up. Also, there is less liquidity for small caps and less interest in small cap IPOs, which we can quantify by looking at how little capital these companies are raising right now.
Why does this all matter and what am I getting at?
On any given day in the last year or so, there have been a few common scenarios:
One, there is a stock that runs up big time in pre-market either with or without news. The action tends to be relatively clean at first with decent volume. Additionally, the price action offers setups that traders are familiar with. And then something happens. The market opens and the entire dynamic changes. Suddenly, the stock no longer is going up, and it doesn’t even go down. It goes sideways, consolidates and chops traders around. If you attempt to trade it with any size, it almost seems as if a market participant has identified you for execution. Then, maybe it crashes suddenly to only surge back up, just to be at the same price it was at the market open. This kind of stock might produce a false volatility halt, baiting traders in a direction that ultimately does the opposite. This is business as usual lately. The algo, now that it has allowed it to go up so freely in pre-market, is ready to take further control of the price action and its mission is to boost the dollar volume throughout the day. Usually, this stock will be interested in selling shares to willing buyers. Increasing the dollar volume is important if you are interested in selling shares. Identifying when this price action happens, can save you.
Two, there is a surprise move when the market opens on a stock that had no activity in pre-market. It makes a quick and massive run with relative ease until whoever was short is finally blown out, or until a big enough seller steps up and stops the trend. The difference here is, on the move up, it has halted several times on light volume and from a risk management perspective, offered no safe entry without chasing. On this particular example, there may have never even been a pull back to enter, or exit, if you were trying to cover. The stock goes up several hundred percent, or more and most people never even capitalized on it. Those that did, may have been killed when it ultimately crashes on a halt down. You maybe have the terrible idea to average in, but then it keeps going lower. Eventually, the stock is down 80% on the day and you realize you’ve been part of a massive liquidation event. This is business as usual lately and it stems from the increasing amount of foreign nano and micro cap IPOs and recently merged special purpose acquisition companies (de-spacs). Identifying when this price action happens, can save you.
Three, small cap traders for whatever reason, tend to avoid grinders that have a slightly higher float, but ultimately still very small in the grand scheme. You know, this stock has the kind of price action that goes steadily up, but is choppy to trade if you are focused on anything less than a 5-minute chart. These stocks tend to not have news but usually have good liquidity. This is the stock that by the time you see it, it’s up over 100%. Then, you have the bright idea to trade the stock, because well, why not? Your trade ends up triggering either the beginning of the end of the rally or a massive squeeze. You continue to trade, digging yourself into a hole you didn’t plan, spiraling into the biggest loss of your trading career. Understanding this price action when it happens and avoid it, can save you.
Those are not the only scenarios, but they are common. There is one major change that happened to stock traders that I did not mention in the beginning of this post, and that’s the implementation of commission free trading across many of the big box retail brokers starting in late 2019.
It took a couple years for the effect of that to be seen in my view. Obviously, nothing in life is free. Social media is free, but it uses your data. Trading is now mostly free, yet, it will force you to show your hand. Although there are brokers that offer direct-routing which could help you, at a cost, from potentially being front-run by math phDs at quant funds, that alone won’t save you and it’s also not a guarantee. As I mentioned, it’s not the only thing that has changed. There is a big mix of new problems for both seasoned and new traders to overcome, many of which we strive to solve. If you have ever encountered any of these scenarios and would like to become a better trader, then give Plan and Trade a try.