Is It Better to Trade Small Caps or Mega Caps

Trading success is usually determined by a motley of factors, and they include a back-tested approach tailored for a segment of the market. This dictates the degree of risk exposure and the potential for gain when trading stocks. One of the decisions to make is whether to focus on mega cap or small cap stocks. While both offer tremendous growth potential, their unique characteristics are so diverse that they require very different trading strategies to achieve success.

Understanding the Market Segments

The most significant difference between the two categories is company size. Mega cap stocks are issued by some of the largest corporations in the world and have market capitalizations of $200 billion and beyond. Examples of such companies are industry titans such as Apple, Microsoft, and Amazon. They make up a significant portion of market indices such as the S&P 500. Small cap stocks, on the other hand, are those that are issued by much smaller and usually younger corporations. They are generally defined as companies with market caps ranging from $300 million to $2 billion. Their stocks are usually included in indices such as the Russell 2000. These types of stocks are usually more flexible when compared to mega caps and have a greater potential for growth.

Mega Cap Issues and Their Allure of Stability and Liquidity

The primary attraction for trading in mega cap stocks lies in their comparative safety and high liquidity. Because they are issued by companies with long-established fundamentals that have a reliable source of revenue, they are able to weather a lot of storms that would typically destroy small cap stocks. They are also usually under tremendous scrutiny by Wall Street analysts as well as regulatory agencies. Their huge market caps and high number of investors also make them less likely to be affected by speculative vagaries. The low volatility characteristic of mega caps is a huge plus in times of market distress. During the COVID-19 crash of 2020, for example, the S&P 500 dropped about 34 percent. In contrast, the Russell 2000 fell by over 40 percent.

Another plus for traders is the high liquidity found in mega caps. Some stocks like Apple have trade volumes that frequently surpass a million transactions on a daily basis. As such, they have very small differences between the bid and ask prices (spread). It is this market depth that allows a trader to execute large orders without unduly affecting share prices. Conversely, in small cap stocks, the daily volume traded is usually smaller and the spreads often wider. As a result, a large trade order may unduly affect the price and make it difficult to realize a profit within a short period.

Small Caps and their Potential for Sudden Growth

While mega caps provide stability, small caps offer the possibility of rapid, explosive growth. This is based on the market principle that it is easier, statistically, for a $500 million company to double its worth than it is for a multi-trillion dollar giant to achieve the same feat. This potentially larger than average rate of return is generally called the size premium. In fact, over the long term, small cap stocks have historically shown a slightly larger annualized rate of return when compared to the mega caps. As such, they reward investors for the greater risk involved during bullish market conditions.

Small caps are also very sensitive to economic cycles, and often lead the market out of bad times into better circumstances. For instance, after the market lows of the 2008 Global Financial Crisis, the rate of return achieved by the Russell 2000 greatly outpaced that attained by the S&P 500, which gave excellent results to the traders who duly recognized, and were alert to economic improvements.

Matching the Market to Your Style

Ultimately, however, the choice of which of the two is better can only be determined by an individual trader’s style and tolerance for risk. Shorter term traders, for example, day traders or high frequency traders greatly need the stability and deep liquidity of mega caps for precision and efficiency in their executions.

Longer term traders such as swing traders who have a high tolerance for risk may achieve their biggest gains in the small caps.