How Effective Is Technical Analysis When Applied To Small Cap Companies?

By: James Woolley

There are a lot of investors who make very healthy profits from applying technical analysis to various stocks. However this generally only works when you apply it to mid or large-cap stocks. If you trade small-cap stocks using nothing but technical analysis, then you will probably end up losing money.

The reason it works so well on the larger and more established companies is because for a start they have strong volumes. People are buying and selling shares in these companies in huge numbers every single day therefore technical analysis works so much better. After all the reason why technical analysis works is because it displays and predicts common human behaviour.

With smaller companies, the volume in trading just isn't there. Therefore any common patterns you may see on the price charts may not mean anything if hardly anyone else is buying or selling shares in these companies.

There is also another fundamental reason why technical analysis is largely a waste of time on small-cap stocks and that's because the real momentum behind a particular price move is very often created by company-specific news, or sometimes it can be nothing more than rumours and speculation. Therefore you cannot legislate for these things and if you apply technical analysis then it will usually be a pointless activity.

Small-cap stocks are very risky and they can move sharply either up or down on even the smallest announcements. Things like overbought and oversold indicators can be completely useless.

For instance a company could appear to be oversold according to several technical indicators such as MACD, RSI and Stochastics, but there could be a fundamental reason why the company is trading so low. They may have just reported lower trading results, for instance, or they may be facing serious financial difficulties, so their share price could fall much much further regardless of what these indicators may say.

So overall I wouldn't recommend you pay too much attention to technical indicators when investing in small-cap stocks, because to a large extent they are irrelevant. A much better strategy is to look at the financial accounts of the company from year to year, keep up with the trading updates and value the company based on future forecasts, both from the company itself and from analysts covering the company.

This way you can come up with a suitable price target and can buy shares in the company when the company is trading at a reasonable price. If you just use technical analysis and nothing else, then you are simply asking for trouble.

Article Source: http://yourfinance.co.za