But what is a microcap stock, and why should investors approach them cautiously and skeptically? In this article, you’ll learn how to identify a micro cap, which exchanges they trade on and why microcaps are often better day and swing trading vehicles than long-term investments.

Key Takeaway

Microcaps are publicly traded companies with market capitalizations under $300 million. Small and often volatile, microcap stocks are among the riskiest types of equities, and investors must use caution when buying. Microcap companies trade on major exchanges like the NYSE and over-the-counter exchanges like OTCQX.

Characteristics of Microcap Stocks

Besides the market cap range, micro-cap stocks often share a few common characteristics. Microcap investors should consider a few factors before putting any capital to work in this volatile market niche:

• Massive price swings: A micro cap company srtock can triple up, get cut in half and then rebound before you take your lunchbreak. When trading microcaps, you must monitor your positions closely and use limit and stop-loss orders.
• Liquidity concerns: Microcaps don’t just have a tiny market capitalization; they also frequently have low free-floating share counts. Low-float microcaps are ripe for manipulation since a relatively small amount of capital can initiate large price cascades. But liquidity is a double-edged sword and large positions in microcap shares might be difficult to unload if the price drops.
• Huge growth potential: Why take the risk if microcaps are volatile and illiquid? Because money talks, and the potential to double or triple your stake quickly is tempting for an investor who doesn’t mind riding the rollercoaster.

You can find great opportunities in microcaps, but the risk level is high. Microcaps require a specific mindset and strict rules. Set profit goals and loss limits, use different order types and never let bad trades compound by getting angry or irrational.

Understanding How a Microcap Stock Works

A micro cap stock faces the same factors influencing other stock sectors, like economic growth, inflation, interest rates, unemployment and other data tracked here on MarketBeat. However, note that regulators treat microcaps trading OTC differently than other stocks that trade on major indices like the New York Stock Exchange and NASDAQ (more on those later). 

Microcaps have often “earned” their market cap. For example, when a company goes public, they don’t want to find themselves trading OTC immediately. Between 2005 and 2021, the median market cap for a company launching an initial public offering (IPO) ranged between $920 million and $1.8 billion. Even in a down year, the median IPO still had a market cap three times as high as the biggest microcaps ($300 million). 

Why would a public company have a market cap under $300 million? Some of the reasons stocks often find themselves in this area include lack of viable products (i.e., biotechs working in tough drug markets), poor management, unsustainable debt or limited liquidity. 

Investing in a micro-cap stock requires more due diligence than usual; you’ll need to dig into the financials and listen to conference calls since these companies get little analyst coverage.

Risk and Reward

Here’s a micro-cap stock example using two companies with similar market caps but very little else in common: Brooge Energy Ltd. (NASDAQ: BROG) and Chicago Atlantic Real Estate Finance (NASDAQ: REFI).

REFI is a real estate investment trust (REIT) investing in commercial loans from cannabis operators. The stock currently has a price over $16, pays an 11% dividend and is up over 14% in the last 12 months. Most notably, REFI has a beta of 0.22, meaning it’s less volatile than major market indices.

Now, look at BROG, where the similarities begin and end with market capitalization. BROG is an energy supplier based in the UAE that offers storage and blending of petroleum products like jet fuel and gasoline. The company pays no dividends; its shares are less than $3, down by over 50% over the last 12 months. 

However, the big drawback for BROG isn’t necessarily the downward price pressure on the shares but the limited liquidity. According to recent data, only 7,900 shares are traded daily on average, making the stock highly volatile and illiquid.

Despite its microcap status, REFI has been a suitable investment vehicle for dividend investors who don’t mind a little added risk. But BROG has been a trading disaster with a plummeting stock price and low volume. Always research microcaps thoroughly because the number of headwinds facing these companies can be vast.

Strategies for Investing in Microcap Stocks

If you can tolerate the volatility and want to grab some quick profits with microcaps, here are a few different strategies to consider:

• Momentum: Traders using momentum strategies use technical indicators to identify trends and then ride the wave up or down. Momentum strategies can be effective with volatile securities like micro-cap stocks but keep your stops tight.
• Growth: If you’re looking for big returns, you’ll need a big catalyst to get it started. Microcap investors (especially in the biotech space) often look for catalysts that could trigger a massive price swing. While many microcaps are unfit for long-term investing, a few rise above the group and enter a new category. 
• Value: The “dismal science” of investing is value, but value can be useful in microcaps when looking for unfairly punished shares. Maybe it’s a drug trial where the headlines are worse than the data or a company going through a transition, but value investors can sometimes find potential in the microcap space.

Navigating Challenges

Investing in microcaps presents several challenges to investors. Remember, microcaps are often small for a reason and information on these firms may be limited. Companies that trade OTC aren’t subject to the same reporting requirements as those on the NYSE or NASDAQ. Therefore, company financial metrics might be tough to find or have questionable accuracy.

Analysts often steer clear of this space, so you’ll be on your own to research, listen to conference calls and study the stock charts of these companies. Additionally, low-float, low-cap stocks are prime targets for pump-and-dump schemes and manipulation.

Microcaps vs. Larger Caps

Large-cap stocks are often called blue chips because they’re the biggest and most successful public companies. Large caps fill the coffers of major stock indices like the S&P 500, NASDAQ 100 and the various ETFs and mutual funds that pack your 401(k) accounts and Roth IRAs. They’re liquid, less volatile and offer more security to investors than microcaps. 

As you go down the market cap ladder, volatility and risk increase. 

Mid-cap stocks are more volatile than large caps, and small-cap stocks are more volatile than mid caps. As the market cap goes lower, the volatility increases since fewer shares are necessary to produce a big move. Microcaps are more volatile than small, mid or large caps due to their size and liquidity.

Pros and Cons of Microcaps

Every investor will need to evaluate the microcap risk/reward tradeoff personally. Here are a few pros and cons to help with the decision.

Pros

The pros include:

• Outsized gains: Is there any explanation needed here? Investors seek out microcaps not because they think they’ll find the next world-changing company but because they can earn big profits quickly.
• No whales: Institutions and money managers tend to focus on large cap stocks, so the likelihood of trading against “sharp money” is lower with microcaps. For day traders, this can be a significant edge.

Cons

The downsides include the following:

• Extreme volatility: Investors must constantly monitor their trades and set hard rules for their entry and exit points. A profitable trade can quickly turn into a devastating loss without a viable trading plan.
• Limited liquidity: Some microcaps have high float counts, but low float stocks are extra risky since they’re more volatile and harder to trade. Every seller needs a buyer, and if you’re trying to unload a large microcap position, you could find a dry supply of buyers for your shares.
• Prime scam targets: Microcaps with low share floats and minimal analyst coverage are often easy targets for pump-and-dump scammers. Since a small portion of the float can induce big swings, scammers buy shares and then “report” a catalyst to their followers on social media or email. When the unsuspecting marks buy the stock, the scammer unloads for a profit and moves on to the next scheme. In contrast, megacap companies cannot pump and dump because the shares are widely distributed across the market.

Investors Must Proceed Carefully with Volatile Microcap Stocks

Many investors have fallen for the siren song of the microcap, but you’ll need to practice caution and restraint to navigate this asset class. 

Microcaps attract scammers like bears to honey since information is often limited, and the float is easy to manipulate with a few well-timed buys. Not all these companies are poorly-run, and some do “grow out” of their microcap status. 

But most traders buying and selling microcaps are simply looking to make quick buck, and you’ll need to adapt your style to that mindset. Cut losers quickly, take profits when you reach your goals. Don’t let a win turn into a loss by holding too long.

FAQs

Here are a few of the most frequently asked questions about investing in micro cap stocks: