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Using CFDs to trade Smaller Stocks

Trading Small Caps
Written by Andy

Most CFD brokers will limit their UK equity market coverage to the constituents of the FTSE 350 index, reason being that these stocks tend to be more liquid and thus providers are able to cover their positions. Quote-driven (SEAQ) shares are less liquid, have a smaller market size of trades and tend to have higher than average volatility. A combination of these factors and a fast, volatile market usually influences brokers to focus on offering only the most popular quote-driven CFDs.

Providers who offer Small Caps

A few main CFD providers like CMC Markets and IG Markets also quote a number of small caps. Here, traders are more likely to take longer term positions probably because people tend to be more cautious with the small caps and tend to adopt more of a buy-and-hold strategy with them.

Risks of Trading Small Caps

Smaller Caps tend to less liquid and highly volatile so CFD brokers will usually have bigger margin requirements in place. So whilst for a FTSE 100 company the initial margin deposit may be as low as 5%, with a small cap this can be 20% or more. This will directly affect the size of the position you can take.

Due to the underlying nature of small caps (lacking in liquidity/very volatile) they are inherently riskier but they allow for higher potential returns if you can tolerate the higher risk. You need to manage the higher risk through diversification across different markets and the use of stop losses (where to place stops is however a bit of a tricky business with small caps as they can fluctuate a lot). Putting stops too tight is likely to result in more trades being closed out prematurely so in such cases it is a better idea to reduce the position size and allow for wider stops so that the maximum potential loss still remains the same.

Trading Smaller Caps via Direct Market Access

Smaller Caps don’t have a lot of liquidity so if you use DMA to trade it’s a case of finding a person who wants to take the opposite position. In such cases it is prudent to limit yourself to the normal market size and not to take too much exposure in a small cap share as otherwise you might have difficulties exiting the position.

Direct Market Access allows you to place buy and sell orders directly on the central stock exchange limit order book which means you can interact with other market participants; with all orders being matched by price/time. Benefits will differ depending on whether you are trading a FTSE 350 share or a Small Cap. DMA small cap stocks tend to have wider spreads and this can be attractive to traders as it allows them the ability to set a price and trade inside the spread potentially improving the price in the process. For example let’s take the case of a small cap stock trading at 145-150p, an investor using a traditional stock broker would have to either buy the offer at 150p or sell at the bid at 145p. For a purchase of10,000 shares this would cost you £500. However, a trade with Direct Market Access could instead attempt to improve on this price. Rather than buying straightaway at the offer of 150p, he could enter a buy order at say 147 and since this would give the trader a good chance of his order being filled as it would make them the best bid in the market (and saving 3p a share). Not to mention that DMA traders also have the ability to take advantage of auctions scheduled at the open and close of the market which are often the most volatile and liquid periods of the day.

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