Index Stocks versus Underlying Stocks

Why Small Cap Stocks Provide More Profits

Most Retail and Technical Trades follow the indexes, assuming that what the indexes do reflects what the other 6000+ listed stocks will do. However, empirical evidence proves that these two factions are not always in sync. The underlying stocks, meaning stocks that are not components of the major 3 indexes are rarely following the index action. Rather the underlying stocks that are not part of the 3 major indexes, often lead or move inadvance of the indexes. 

Following Indexes and analysis is fine if you only trade index components. However when considering Index Stocks versus Underlying Stocks, realize that limits your ability to make higher profits and trade more often because the underlying stocks are where much of the activity is these days especially in the summer time and the fall.

Remember, learning Technical Analysis is not going to teach you how to trade. Often times traders assume that if they learn Technical Analysis they know how to trade stocks, which is not true.

Technical Analysis is one small, but important part of trading stocks. The most influential technical analysts in the world today work for Sell Side or Buy Side Institutions, but they are not traders. Trading includes Technical Analysis, but being an expert technical analyst does not make you a trader. Always consider this fact when you are trading, because It matters.

Retail Traders are often caught by surprise when the market moves suddenly with momentum. This is because they merely follow the 3 big indexes, and they do not lead the market up or down.

Another main difference in considering Index Stocks versus Underlying Stocks is the simple fact that most of the index components are used in Charters for the creation of a Mutual Fund or Pension Fund, and Trusts are used for creation of Exchange Traded Funds ETFs, E-Minis, and other derivatives. This sets aside a huge chunk of the outstanding shares of stock in long-term accounts. These stocks are held not so much for rising values, but because the Independent Investors who buy or invest in such funds want big name companies because they believe they are “safer” than small cap companies. Mutual Fund Investors, which are known as “Main Street” actually have far more clout than they realize. Mutual Funds will not be created that do not sell.

Also the 3 top indexes have a lot of overlap. All of the Dow components are in the S&P500. Almost all of the NASDAQ 100 are in the S&P500, with only a handful or smaller companies listed on the NASDAQ index are not part of the S&P500.  

This or course sounds like blasphemy to older traders who are avid devotees of the index analysis. However just analyzing the major indexes and trying to figure out what is going on in the market will lower your profitability. If you are a Hobby Trader doing this for fun, then there is no problem. If you are serious about making a living from trading stocks or options, or need to augement your monthly income trading part-time then it is an entirely different matter.

Retail and Technical Traders should embrace every potential trade, and not limit themselves to just big name companies. High Frequency Traders HFTs exploit the index stocks by front running the more popular stocks, because they can see the retail broker pre-market orderflow. Also intraday volume on big name companies has declined in recent years, making trading big cap stocks higher risk due to low liquidity during the trading day. With shares held in Charters and Trusts for long-term, fewer institutions need to buy or sell the big name stocks so these have less trading activity.

Small Caps move with more momentum because the only Market Participant Groups who invest or trade these stocks are the larger institutions. Because these smaller cap stocks have very high institutional ownership with often 95-99% of the total shares outstanding held by institutions, price moves with faster momentum due to supply and demand. Institutions make a lot of income from the small cap stocks.

Also Professional Traders prefer the small cap stocks, especially now that the Securities and Exchange Commission SEC small cap price spread pilot test program is creating more interest in small cap stocks. See chart example below for HubSpot Inc. (HUBS: NYSE)
chart example for hubspot inc. with fast moving small cap stock - technitrader
HUBS is one of numerous examples of how fast small caps can and do run. This provides excellent point gain profits for Swing, Day, Intraday, and Option Traders. The more a stock runs the more income you can earn and the fewer trades you need to do which equates into lower trading costs, less risk, fewer losses, and higher monthly income.

Summary
Underlying stocks that are not components of the top 3 indexes provide many short-term trading opportunities most Retail Traders miss.

No stocks mentioned in these blog lessons are recommendations. All charts used are for educational purposes only.

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Trade Wisely,
Martha Stokes CMT
TechniTrader technical analysis using a StockCharts chart, courtesy of StockCharts.com


Chartered Market Technician
Instructor & Developer of TechniTrader Stock and Option Courses
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Disclaimer: All statements are the opinions of TechniTrader, its instructors and/or employees, and are not to be construed as anything more than an opinion. TechniTrader is not a broker or an investment advisor; it is strictly an educational service. There is risk in trading financial assets and derivatives. Due diligence is required for any investment. It should not be assumed that the methods or techniques presented cannot result in losses. Examples presented are for educational purposes only.