Trading Small Caps: Communication Is Key

With Daphne Chang, Dealer, Acorn Capital

Daphne ChangWhile liquidity is important for all traders, it is crucial for small cap traders. Portfolio managers regularly demand positions of at least 5% of a company’s holdings, so finding and executing block trades is always the priority.

Clear communications and close coordination with our PMs is critical to understanding stock valuations and how target weights for the fund are to be established. To have efficient communication, we have regular research meetings with our portfolio managers and analysts to discuss about our portfolio. Apart from the research meetings, we have developed our internal research system for the portfolio managers to upload their research reports or notes at anywhere and anytime. Once their reports or notes are uploaded in the system, the trading desk will receive the notification emails and can quickly pick up the revaluation from the PMs in order to take proper action in the market.

In this space, the trading desk’s activities cannot simply be limited to mechanically executing trades. We need to be up to speed in all aspects of the market, whether monitoring the actions and movements of brokers, IOI, turnover changes, and changes in substantial holders.

Armed with this knowledge, our desk has far better opportunities to secure blocks at preferred prices at the right time.

Managing relationships
Developing sound relationships with local brokers is important, particularly those who specialise in small caps. Well maintained broker relationships keep the trading desk abreast of underlying trading activity, potential placements and other corporate opportunities. We give high rankings for the brokers who can provide good small cap flow, deep knowledge about the small cap market, and good effort on delivering the block trades.

In situations where there is high liquidity, our adoption of algo trading strategies has helped us optimize our execution of trades enabling a lower profile in executing larger positions which might create undesired uncertainty in the market. Empowering dealers to act independently is important in the small cap space because market conditions often require nimble and effective responses. Naturally, PM’s will make the buy-sell decision but how the order is executed must be the province of the trading desk. This is where traders must be au fait with how PM’s have arrived at their valuations and the underlying investment case with catalyst expectations. These provide the desk with guidance for an acceptable price when seeking liquidity. In addition, our dealers can see each other’s trades at our own trading screen and are all aware of the valuation/target weights of each single trade. By sharing all the information together and working as a team, the trading desk can maximise the performance.

By the same token, the communication must go both ways with the PM. For example, unusual price movements and flows must be fed back to the PMs regardless of their buy-sell decision or the progress of the execution.

Technology
Technology can often have a limited application in small cap dealing. Transaction cost analysis can be of limited use in providing information to analyse trades. The methodology for valuing a trader’s performance is generally not a matter of whether the trader can secure a block above the VWAP price or below the VWAP with 60 days to complete the target position, for example. Performance is generally a function of how efficiently the trader can execute the PM’s decision and achieve the desired portfolio position.

Adopting our algo strategy has allowed us to better exploit liquid conditions, but traditional knowledge and relationships are still far and away the most important resources for traders in small caps.

What sets us apart, I believe, is the strength of our Portfolio Managers in research and analysis. The fact is, market research for small cap stocks is often very limited and the brokers covering these companies can be very thin on the ground. There are often no research reports from external sources available, which means the quality of our own research needs to be world class.

So, the performance of a trader is directly related to the performance of the PMs and the quality of their communications. In this way, our trading desk’s knowledge has been bolstered by regular research meetings where we discuss all manner of topics ranging from broker movements to market flows.

Traders who have relied mainly on technology for executing their trades may find adjusting to the small cap space challenging initially if lacking the fundamental experience and knowledge derived from such close relationships.

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